Sunday, December 21, 2008

Why Bubbles Are Perfectly Rational & Unavoidable

Most bubbles are the product of more than just bad faith, or incompetence, or rank stupidity; the interaction of human psychology with a market economy practically ensures that they will form. In this sense, bubbles are perfectly rational—or at least they’re a rational and unavoidable by-product of capitalism (which, as Winston Churchill might have said, is the worst economic system on the planet except for all the others). Technology and circumstances change, but the human animal doesn’t. And markets are ultimately about people.

Here are three thoughts about bubbles that I hope we all can keep in mind.

1. Bubbles are to free-market capitalism as hurricanes are to weather: regular, natural, and unavoidable. They have happened since the dawn of economic history, and they’ll keep happening for as long as humans walk the Earth, no matter how we try to stop them. We can’t legislate away the business cycle, just as we can’t eliminate the self-interest that makes the whole capitalist system work. We would do ourselves a favor if we stopped pretending we can.

2. Bubbles and their aftermaths aren’t all bad: the tech and Internet bubble, for example, helped fund the development of a global medium that will eventually be as central to society as electricity. Likewise, the latest bust will almost certainly lead to a smaller, poorer financial industry, meaning that many talented workers will go instead into other careers—that’s probably a healthy rebalancing for the economy as a whole. The current bust will also lead to at least some regulatory improvements that endure; the carnage of 1933, for example, gave rise to many of our securities laws and to the SEC, without which this bust would have been worse.

3. We who have had the misfortune of learning firsthand from this experience—and in a bust this big, that group includes just about everyone—can take pains to make sure that we, personally, never make similar mistakes again. Specifically, we can save more, spend less, diversify our investments, and avoid buying things we can’t afford. Most of all, a few decades down the road, we can raise an eyebrow when our children explain that we really should get in on the new new new thing because, yes, it’s different this time.

~Henry Blodget in the December issue of "The Atlantic"

43 Comments:

At 12/21/2008 8:25 PM, Anonymous Anonymous said...

More utter nonsense. The boom bust cycle only came into existence when paper money was created in the 17th century. There is no recorded instance of it before then. In 1912 Ludwig Von Mises, the preeminent Austrian economist and mentor of Friedrich Hayek, gave the explanation of how these booms and busts come about in The Theory of Money and Credit.

It's so incredible to me that so few free market economists are entirely unaware of this work, or Mises' magnum opus, Human Action.

For an introduction, please read Gary North's excellent Mises on Money.

 
At 12/21/2008 8:26 PM, Anonymous Anonymous said...

sorry, should be "so many free market economists..."

 
At 12/21/2008 9:01 PM, Anonymous Anonymous said...

I may have misunderstood but you seem to say that trying to stop bubbles is pointless. and then praise efforts such as the SEC which seem designed to abate bubbles.

 
At 12/21/2008 9:06 PM, Anonymous Machiavelli999 said...

Anonymous,

This post lies at the heart of most of our arguments on the recession. There seem to be 3 school of thoughts on this. The first thought, espoused by anonymous, is that government cause bubbles and business cycles. It comes from the theory of Austrian business cycle and is COMPLETE AND UTTER BS. You are wrong anonymous that few economists are aware. Many are aware of the Austrian school of thought and all major economists of the 20th century have examined it. Both Keynes and Friedman examined the theory and eventhough both disagree of what government policy should be towards the economy, both agree that when you examine of what actually happens during a recession it does not support the Austrian business cycle theory. The belief that recessions are there to clean out the excesses from they economy has no proof. It is morally seductive because its so simple. But I compare it to the theory that the earth is flat. It may seem like it is, but math and evidence proves that its round and invisible force is pulling us in from the center.


The Austrians themselves admit that they don't use evidence and models to backup their theories. They claim that human behavior is too complex to model, but that makes me even more skeptical that it can just be inferred. And my suspicions are well founded because they assume things like rational behavior and perfect competition.

Here is a more detailed rebuttal of the Austrian theory by Krugman:

http://www.slate.com/id/9593

This is the best line:

"The hangover theory is perversely seductive—not because it offers an easy way out, but because it doesn't. It turns the wiggles on our charts into a morality play, a tale of hubris and downfall. And it offers adherents the special pleasure of dispensing painful advice with a clear conscience, secure in the belief that they are not heartless but merely practicing tough love.

Powerful as these seductions may be, they must be resisted—for the hangover theory is disastrously wrongheaded..."


The serious argument is between people who think bubbles are unavoidable and people who think they can be spotted and deflated slowly instead of allowing them to pop.

 
At 12/21/2008 9:25 PM, Anonymous poor boomer said...

Extraordinary Popular Delusions and the Making of Money?

 
At 12/21/2008 9:27 PM, Blogger PeakTrader said...

Just because something wasn't recorded, doesn't mean it didn't exist. Boom/bust cycles are likely caused by uneven labor supply. There was an economic boom from 1946-64 (and bull stock market), which paralleled the Baby-Boom generation born between 1946-64; the 1982-00 economic boom paralleled with the children of the Baby-Boomers, born between 1982-00, i.e. Gen Y. The prior long-wave bust cycle, from 1965-82, was during the birth of Gen X. The last of the Baby-Boomers will reach 65 in 2029. There were long-wave bust cycles in the 1870s, 1930s, and 1970s. Moreover, I may add, Keynesian economics softened the 10-year bust of the 1970s.

Also, some find asset cycles or bubbles (not to be confused with economic cycles of goods and services) annoying. However, they're only residuals of economic policies.

 
At 12/21/2008 9:34 PM, Blogger PeakTrader said...

Also, I may add, the 35-54 age group, i.e. 'prime-age' is the most productive group, based on education, experience, and training. The 55-64 age group is the second most productive group. An increase in the 16-24 and over 65 groups have negative effects on GDP growth. If you look at long-wave economic booms and busts, uneven labor supply is the most powerful factor. Afterall, economies are made up of people.

 
At 12/21/2008 10:57 PM, Blogger cramerj said...

The over 65's are basically not allowed to work - in general.
As a lot of jobs do not involve ditch digging etc they should continue employment.
Why not just discourage retirement.
It is way over advertised. And you earn money then when you really need it.

 
At 12/22/2008 1:33 AM, Anonymous Anonymous said...

Machiavelli, David Gordon completely dismantles Krugman's facile analysis of the business cycle theory.

As Gordon points out, Krugman didn't even know the origin of the theory and mis-attributed it to Schumpeter instead of Mises.

The very fact you're appealing to Krugman, who is famous for spouting economic fallacies, shows you don't have a very good grasp on economics.

 
At 12/22/2008 1:37 AM, Anonymous Anonymous said...

Also, Bob Murphy has another devastating critique of Krugman's Keynesian fantasy that consumers cause recessions

 
At 12/22/2008 8:49 AM, Anonymous Machiavelli999 said...

anon,

This isn't really the place to have a very detailed discussion of the business cycle, but all I will say is that the Austrian school has not been totally ignored by mainstream economists. It is known, but regarded as a theory that doesn't fully explain what happens.

Milton Friedman is as close to anti-Krugman and anti-Keyenes as you can get and even he said:

"The Hayek-Mises explanation of the business cycle is contradicted by the evidence. It is, I believe, false."

As Krugman says, it is a good story for investment cycles, but doesn't really explain why depressions happen.

Oh and that link you sent about Krugman's economic fallacies is a typical example of the Austrian argument. They use morality rather than facts and evidence to make their argument.

 
At 12/22/2008 9:54 AM, Anonymous Anonymous said...

It seems to me that many people attack the Austrian theories without actually knowing much about them. The simple fact is that the Austrian school has a very good record in spotting bubbles and seeing the unintended consequences of interventions that the statist economists support.

The Austrians get little respect in government circles because they have shown that governments make things worse and usually do little more than pick winners and losers in the hampered marketplace. They get little respect from the mathematical economists because they understand that a complex, non-linear system cannot be explained by making the type of assumptions that would be needed to apply equations. As objective, rational individuals we should be able to see through the false arguments and examine the evidence directly. There is no doubt that managed economies do not do as well as those that are freer and that the mainstream economic theories have failed miserably.

 
At 12/22/2008 11:03 AM, Blogger lineup32 said...

economics appears to have closer ties to astrology then science and most if not all University level study of economics is on par with Black Studies and other such. While life and physical sciences has generated significant progress for human lifestyle little other then confusion reins from economist.

 
At 12/22/2008 11:28 AM, Blogger Michael Smith said...

Machiavelli claimed:

As Krugman says, it is a good story for investment cycles, but doesn't really explain why depressions happen.

I don't know why you or Krugman believe this. The Austrian theory explains the Great Depression perfectly. Read it for yourself here: Rothbard on the Depression

Machiavelli also said:

Oh and that link you sent about Krugman's economic fallacies is a typical example of the Austrian argument. They use morality rather than facts and evidence to make their argument.

Nonsense. The "broken window" fallacy mentioned in that link has nothing to do with morality. Do you even know what the “broken window” fallacy is? I suspect you don’t.

The “broken window” fallacy is the act of focusing on only the directly obvious, immediately seen effects of an event while ignoring the other, less obvious effects.

Krugman commits precisely that fallacy when he promotes the idea that the destruction of office buildings on 9/11 will have positive economic effects because it creates the need to replace them. This utterly ignores the huge economic loss incurred by the owners of those buildings. It ignores the fact that all the money that will have to be spent replacing those buildings is money that would have been spent on something else had the attacks not occurred.

So Krugman points to the workers employed in the rebuilding project and concludes: “See, this has created new jobs.” What he doesn’t mention -- either out of ignorance or sheer mendacity -- is that whatever other projects the company had intended to fund with this money -- the money now being spent to rebuild the destroyed structures -- must now be cancelled, thereby eliminating whatever employment those projects would have created.

And no, it changes nothing if the money comes from an insurance company. If an insurance company pays for the rebuilding, that simply means that whatever else the insurance company was planning to fund with that money will have to be cancelled, with whatever corresponding economic loss that entails.

So the fallacy looks only at the jobs created by the rebuilding project while ignoring all the jobs lost when funds have to be diverted from other projects to pay for the rebuilding.

That’s the “broken window” fallacy. Now, what does that explanation have to do with morality?

 
At 12/22/2008 11:36 AM, Blogger Marcus said...

Krugman lecturing Austrians about moralizing is the ultimate in hypocrisy.

Reading his blog and NYTimes articles, what is his theory of the current bubble? GREED!!!

That makes for a fine story, the greedy capitalist laying wreckage to the financial system through his greedy pursuit of profit but it's not much of a theory.

 
At 12/22/2008 1:02 PM, Blogger David Peterson said...

More utter nonsense. The boom bust cycle only came into existence when paper money was created in the 17th century. There is no recorded instance of it before then.

Isn't this also about the same time industrialization started as well? I don't think that there were a whole lot of economies that grew fast enough to even have booms and busts. IIRC one of my professors cited a calculation that prior to the industrial revolution someone had estimated (and I really wish I knew where he got this figure) that the entire global economy grew about 1% every 100 years.

I think both you and Machiavelli are wrongfully looking for a single cause of all bubbles. A wise economist would ask if it's true for this bubble, is it necessarily true for all bubbles? And are there other factors that contribute to bubbles to varying degrees?

 
At 12/22/2008 1:21 PM, Anonymous Machiavelli999 said...

Anonymous wrote:

"There is no doubt that managed economies do not do as well as those that are freer and that the mainstream economic theories have failed miserably."

How have they failed miserably? I mean the Federal Reserve has been around since 1913. The Bank of England has been around since the 1600s. Are you going to tell me we are worse off now than we were in 1913 or the 1600s?

Also Mr. Austrian, I am waiting for my hyper-inflation. Where is my $2,000 gold? Where is my $300 oil? Peter Schiff (Ron Paul's economic advisor) is confused why the dollar is going up:

http://seekingalpha.com/article/111857-peter-schiff-outlook-for-the-gold-market?source=wildcard

How do the Austrian economists explain for the massive deflation during the Great Depression despite loose monetary policy and huge fiscal spending? (And even when the economy recovered in the 40s there was no hyper inflation? How did this happen?) How do the Austrians explain deflation in Japan after they set rates to 0% and kept them there for years? How do the Austrians explain deflation right now?

 
At 12/22/2008 2:40 PM, Blogger Michael Smith said...

Machiavelli asked:

"How do the Austrian economists explain for the massive deflation during the Great Depression despite loose monetary policy and huge fiscal spending?"

You are confusing yourself by equating deflation with any fall in prices and inflation with any rise in prices. The Austrians avoid this confusion by defining deflation as a fall in the money supply and inflation as an increase in the money supply. Whether or not those changes in the money supply result in price changes depends on a number of factors.

In the Great Depression, there was indeed deflation caused by thousands of bank failures -- failures of fractional reserve banks that wiped out billions of dollars in the form of fiduciary media, i.e. checking deposits. The disappearance of that fiduciary media overwhelmed the Fed’s efforts to inflate -- so the money supply contracted considerably. That’s deflation. It caused a corresponding collapse in aggregate demand, which caused falling prices. So, in that case, the deflation did produce falling prices.

"How do the Austrians explain deflation right now?"

We don’t have deflation right now. We have a recession, triggered by the collapse of the housing bubble, with a corresponding increase in unemployment in all the housing related industries and a corresponding fall in demand leading to a fall in prices -- with the entire situation made much, much worse by the actions of both Congress and the Bush administration intervening in the economy. Those interventions -- coupled with President-Elect Obama’s promises of additional disastrous interventions -- have created great uncertainty and convinced many people to hold off on purchases and investments. This, in turn, leads to an additional contraction in economic activity as people delay major purchases such as automobiles.


Also Mr. Austrian, I am waiting for my hyper-inflation. Where is my $2,000 gold? Where is my $300 oil?

What’s wrong -- weren’t you content with the preposterous rise in housing prices and gasoline at $4/gallon? Apparently, your understanding of Austrian economic theory consists of the belief that it predicts an immediate hyper-increase in consumer prices whenever there is an increase in government spending. That only shows that you don’t understand the theory at all.

 
At 12/22/2008 2:59 PM, Blogger Michael Smith said...

Marcus wrote:

“That makes for a fine story, the greedy capitalist laying wreckage to the financial system through his greedy pursuit of profit but it's not much of a theory.”

You’re right Marcus, it’s not much of a theory. The wisest words I’ve heard about that argument is that blaming this crises on greed is like blaming an airplane crash on gravity. Greed, like gravity, is always present. The issue is, what went wrong in this case?

We know one thing for sure. The Federal Housing Authority, the Federal National Mortgage Association, the Federal Home Loan Mortgage Association, the Community Reinvestment Act -- these were not created because private lenders were making too many risky loans to unqualified borrowers. To the contrary, the whole justification for these particular government interventions in the economy was the claim that under a free market, mortgage lenders were too “selfish”, too “stingy” and too “greedy” to make home loans to lower income applicants.

But now that too many such loans have been made, who are we told is to blame? Those very same “selfish”, “stingy” and “greedy” lenders. Those pushing that argument have an unbelievably low opinion of our intelligence.

 
At 12/22/2008 3:57 PM, Blogger 1 said...

"Here is a more detailed rebuttal of the Austrian theory by Krugman"...

Krugman?!?!

ROFLMAO!

Thanks mach, its always entertaining to see which way you'll fall on a particular subject lately...

 
At 12/22/2008 4:31 PM, Anonymous Machiavelli999 said...

"We don’t have deflation right now."

This is absolutely laughable. Tell that to the people who have held their money in gold and oil and other commodities. Tell that to the people who bet big against the dollar. Tell that to Peter Schiff's clients who have lost millions with him and his Austrian economics based investment strategy over the past year.

Look at the CPI numbers in the last few months. The headline number has turned very negative and the core rate is in danger of turning negative. Just go look at the gas prices at your local station and compare it to what it was 6 months ago.

I do agree with you on one thing. I do agree we will see heightened inflation in 2010 and beyond. But that will be a good thing. It will be a sign that the policies of the central banks are working because right now they are not. Ben Bernanke is probably begging for some inflation. Any inflation! It is not a given that printing trillions of dollars will actually result in higher prices. Again I point you to Japan. 0% interest rates for years and years, stimilus package after stimilus package, national debt running at all time highs lead to.... 0-1% inflation over the course of a decade. And this was not a good thing!

 
At 12/22/2008 4:31 PM, Anonymous Machiavelli999 said...

Oh and please Michael Smith don't start the old "CRA, Fannie and Freddie caused all this" memo. You should read more about what the CRA guidelines actually said. To quickly summarize, in the 70s banks would literally take a red marker and redline certain communities as uninvestable. And if you were from those areas, no matter how good your credit record was, you wouldn't get a loan. A perfect example of group think and irrational behavior in a free market system. Anyway, the government tried to get banks to invest in those communuties through the CRA.

Now if you look at where the foreclosure crisis is centered it is in the suburbs of California, Florida, Arizona and Nevada. Not exactly the ghetto. Also, the majority of the subprime loans were originated by independent lenders who were not subject to any of the CRA guidelines. Also, no where does it instruct investment banks to buy toxic mortgage backed securities made up of these subprime mortgages and also to lever up to 30x to increase the "returns" on these investments.

It is also very telling that when the heads of the failed investment banks were called to testify, not one blamed Fannie, Freddie or the CRA for what happened even though they all had all the incentive in the world to blame some sort of government regulation.

 
At 12/22/2008 5:23 PM, Blogger 1 said...

"Oh and please Michael Smith don't start the old "CRA, Fannie and Freddie caused all this" memo. You should read more about what the CRA guidelines actually said"....

Ahhh, maybe you should reread those supposed guidelines mach and the ones that were generated during the Clinton administration while you are at it...

Maybe the words of Janet Reno will enlighten your stance on yet another bit of slobbering socialist nonsense that you seem to applaud...

Last month IBD ran an editorial that reads in part: The Community Reinvestment Act is to blame for the financial crisis, but it so powerfully serves Democrats' interests that they'll do anything to protect it — including revising history...

Are you falling for revisionist history mach?

"Now if you look at where the foreclosure crisis is centered it is in the suburbs of California, Florida, Arizona and Nevada. Not exactly the ghetto"...

Define 'ghetto'...

About half of all mortgages for blacks and Hispanics are subprime, versus roughly one-sixth for whites. Not surprisingly, the biggest home price collapses have occurred in heavily Hispanic cities such as Las Vegas, Miami, Phoenix, and Los Angeles

"It is also very telling that when the heads of the failed investment banks were called to testify, not one blamed Fannie, Freddie or the CRA for what happened even though they all had all the incentive in the world to blame some sort of government regulation"...

Hmmm, so now you are applauding sniveling cowardice also...

Unbelievable...

 
At 12/22/2008 6:39 PM, Blogger QT said...

"The boom bust cycle only came into existence when paper money was created in the 17th century."

Apparently, they don't teach history at university anymore. The tulip bulb craze started in the 16th century and ended in 1637. One might also cite hyperinflation in ancient Rome due to debasement of the currency.

The Austrian school is not a destination but a beginning. It offers many useful insights but there is a great deal beyond Mises & Hayek. One learns more by dispensing with hagiography and suspending one's preconceived notions. There is something to learn from even Krugman and Keynes.

The challenge is to learn in spite of one's limitations and prejudices.

 
At 12/22/2008 7:16 PM, Anonymous Machiavelli999 said...

QT,

You gave the best quote of the thread. One thing I hope that comes from on Obama presidency is that "idealogy" becomes a bad word and pragmatism truimphs over everything else in public policy making.

As for "1", I am too lazy to point out all the arguments that the CRA did not cause anything, so I'll just provide you with this quote by FDIC chairwoman Sheila Bair:

"“Point in fact,” she said, “only one in four higher-priced first mortgage loans were made by CRA-covered banks during the hey-day years of subprime mortgage lending. The rest were made by private independent mortgage companies and large bank affiliates not covered by CRA rules.”

And “Let me ask you,” she proceeded. “Where in the CRA does it say to make loans to people who can’t afford to repay? Nowhere.” The facts are simple, Bair said. The lending practices that are causing problems today were driven by a desire for more market share and revenue growth, not because the government encouraged certain lending practices."

Also, even if I agreed that government subsidies perversely affected the mortgage origination process, they did not subsidize the securitization of mortgages. I am glad that no investment bank head is blaming the CRA for their own mistakes because it would be like the government subsidizign bananas and then you buying a lot of bananas putting it on your roof, having the roof collapse and then you blaming the government subsidies for what happened.

 
At 12/22/2008 7:25 PM, Blogger 1 said...

"I am too lazy to point out all the arguments that the CRA did not cause anything, so I'll just provide you with this quote by FDIC chairwoman Sheila Bair"...

The fact of the matter is that Blair is a liar but then again you mach were also to ready to quote Krugman...

I need a baseless, factless quote from a government parasite like Custer needed another indian...

 
At 12/22/2008 10:34 PM, Blogger QT said...

1,

Krugman isn't my favorite economist although I do agree with his position on ethanol (eventually you find common ground if you wait long enough and trust me it has been a wait). That being said, just dizing the guy is pure ad hominem ("attack the man").

When you wish to deconstruct an argument and refute the logic, your position will gain infinite credibility.

"you mach were also to ready to quote Krugman..." Taint by association ie. you must be an idiot if you quoted this person I don't agree with? It doesn't get much thinner than that.

What is curious is that bubbles are referred to as rational when they are the result of human activitity. Isn't human activity inherently irrational?

 
At 12/22/2008 10:56 PM, Anonymous Machiavelli999 said...

1,

OK, now I have more time to discuss this.

Alrite 1, give me your explanation for not just the US housing bubble, but the global housing bubble. Prices in housing are crashing around the world right now. Spain is particularly hard hit example. What is your explanation for their housing bubble and crash? Did the CRA cover Spanish neighborhoods too? And how did all the housing bubbles around the world happened to originate and pop all at around the same time?

Oh and some more questions for the Austrians, if any are listening. You blame our mess on poor monetary and fiscal policy creating excesses in the system that this recession now is curing. But then how do you explain a country like Germany which didn't have massive credit expansion, consumer frency, house-price bubbles and soaring budget and trade defecits and yet....it too is facing a tough recession going forward??

 
At 12/23/2008 8:06 AM, Blogger Michael Smith said...

Machiavellis wrote:

“This is absolutely laughable. Tell that to the people who have held their money in gold and oil and other commodities. Tell that to the people who bet big against the dollar. Tell that to Peter Schiff's clients who have lost millions with him and his Austrian economics based investment strategy over the past year.”

An emotional exhortation is not an argument and proves nothing.

He went on:

“Look at the CPI numbers in the last few months. The headline number has turned very negative and the core rate is in danger of turning negative. Just go look at the gas prices at your local station and compare it to what it was 6 months ago.”

Yes, prices on many things are falling. But every time you find yourself wet, do you conclude it has been raining? Even when you step out of the shower or the pool? No, you would never insist that all three instances of you being wet constitute rainfall. Why, then, do you insist that every instance of falling prices be called "deflation"?


And more:

“As for "1", I am too lazy to point out all the arguments that the CRA did not cause anything, so I'll just provide you with this quote by FDIC chairwoman Sheila Bair:”

The argument from authority. If a government regulatory official says regulations are not to blame, this convinces you?

And more:

And “Let me ask you,” she proceeded. “Where in the CRA does it say to make loans to people who can’t afford to repay? Nowhere.”

This is a particularly vicious piece of evasion. No, the CRA doesn’t explicitly demand that you make loans to people who cannot repay. Just as the Equal Employment Opportunity Act doesn’t explicitly demand that you hire blacks. In both cases, the legislation merely puts the burden of proof on the business to prove -- at any random time the government demands and to the satisfaction of bureaucrats possessing arbitrary power ungoverned by any rules of evidence -- to prove that one did NOT discriminate. Evaluate for yourself the inevitable result of that requirement.

Also, even if I agreed that government subsidies perversely affected the mortgage origination process, they did not subsidize the securitization of mortgages.

What entity acts as the lender of last resort and has so consistently followed a policy of inflation that virtually every American views the purchase of a home as a good investment? Hint: is isn’t the free market.

“Alrite 1, give me your explanation for not just the US housing bubble, but the global housing bubble………….Prices in housing are crashing around the world right now. Spain is particularly hard hit example. What is your explanation for their housing bubble and crash? Did the CRA cover Spanish neighborhoods too?

There is no point in giving you any sort of explanation for anything. When I explain one phenomena -- such as how deflation occurred in the Great Depression in the face of aggressive attempts by the Fed to inflate -- you simply drop the issue and demand an explanation for some other phenomena.

No, the CRA did not cover Spain, but that doesn’t prove that it had no effect here in the U.S.

What’s more, a housing bubble in multiple countries is exactly the sort of phenomena Austrian economic theory would predict, given the wide-spread government practice of trying to stimulate economic growth through the inflation of a fiat money supply by a central bank. That practice has caused a decades long increase in asset prices. Why is anyone surprised to learn that investors -- in Spain and elsewhere -- became convinced government would never give up on its tactic of inflating away its debt obligations? Or that it would never allow major financial institutions to fail?

The evidence suggests that your inflationary, statist/interventionist chickens have come home to roost -- not just here in the U.S. but elsewhere as well. How long you will go on evading that evidence remains to be seen.

 
At 12/23/2008 8:11 AM, Blogger Michael Smith said...

QT wrote:

There is something to learn from even Krugman and Keynes.

Such as?

 
At 12/23/2008 9:09 AM, Blogger 1 said...

Thank you michael smith: "Such as?"...

Exactly!

If there is anything to learn from Keynes and Krugman, its not to listen to them...

 
At 12/23/2008 9:31 AM, Anonymous Machiavelli999 said...

My example of crashing commodity prices and CPI was no "emotional exhortation", it was to show you that there is no inflation. What prices are rising Michael Smith, because I would sure like to know and invest in that field?

For a more clear example of what the market thinks inflation expectations are look at treasury yields. Yesterday, the government auctioned of $30 billion in debt and it went for a paltry yield of 0.92%. Now why would people be willing to lock their money in at that rate. Because the expectations of the market is that we will see deflation and the real yield is higher than 0.92%. Also, look at the spreads between TIPS (Treasury Inflation Protected Securities) and comparable US notes. The spread is at all time lows. Which means the market doesn't really care about "inflation protection" right now. So, what I am telling you is not "emotional exhortation", its facts and evidence. You have yet to show any evidence of inflation. And no, the central banks setting the rates to 0% and printing lots of money does not automatically imply inflation.

And I am not ignoring your explanation of deflation during the Great Depression. On the contrary, I believe the same is occurring right now. Deflationary forces are in control right now despite what the central bank is trying to do.

As for you explanation of the global housing bubble, well at least you are getting a little closer to the truth. Blaming the central banks is a tiny bit more credible than blaming the CRA and I agree they do share in some of the blame by keeping rates too low for too long after the dotcom bubble burst and we can have a serious discussion whether all the blame lies in the central banks, but as long as you continue to blame the CRA this is not possible.
Sheila Bair was not lying when she said that 80% of the subprime mortgages were originated by firms that were not subject to CRA guidelines. In fact of the 300+ lenders that have gone bust since Summer of 2007 none have had to follow any CRA guidelines.

And again I repeat my questions from before. Why was there no credit/housing meltdown from 1977 to 2005? Why did 30 other countries, none of which have are covered by the CRA, have a remarkably similar housing boom and bust to the USA?

 
At 12/23/2008 12:10 PM, Blogger Marcus said...

"My example of crashing commodity prices and CPI was no "emotional exhortation", it was to show you that there is no inflation."

Machiavelli, you seem to me to be confusing issues. Austrian theory does not predict inflation during the contractionary phase of a bubble. It predicts DEFLATION.

First, I want to say that while it is true that many fanatical libertarians may dismiss Keynes for no more reason than his economics are largely used to justify government expansion, you seem to be making the same mistake in reverse. You seem to dismiss the useful insights Austrian theory gives us for no more reason than you dislike libertarians (apparently).

To the point. My understanding of Austrian theory is that it explains the boom/bust cycle through credit expansion and contraction. Credit expansion is the same thing as expanding the money supply. And credit contraction is the reverse.

It is during the boom phase of credit expansion when Austrian theory predicts inflation. And in fact, if we look at the boom phase of the latest bubble that is exactly what we see, significant inflation in housing and commodity prices.

Eventually, some hard limit is hit. In the case of housing, that hard limit is peoples incomes. There is a maximum limit on what people can afford to pay in monthly payments no matter how innovative lenders are. So a bust occurs when finally, people can't turn over their investments (ie. flip houses).

When the credit contracts Austrian theory predicts DEFLATION because credit contraction is the same thing as destroying money. And in fact, DEFLATION is exactly what the monetary authorities are worried about.

Krugman says recessions are caused by people hoarding money but gives no explanation as to why suddenly people are hoarding money. Austrain theory does. As credit dries up (and money contracts) credit is harder to come by which presents a cash flow problem for companies. In response they begin to hoard cash (which creates even more deflationary pressure).

During the down turn, people become concerned about the future. They become more interested in paying down debts rather than taking on more debt. This too is contractionary because when a debt is paid off and no new loan is made, money is destroyed.

I think Austrian theory is useful and descriptive of all this up to this point. That doesn't mean it explains everything. It's not the unified theory of economics.

 
At 12/23/2008 12:30 PM, Blogger QT said...

"Such as"

Nice one, Michael.

Didn't say that I agree with Krugman or Keynes on much of anything just that one needs to be open to ideas irrespective of the source. Even Krugman can get the right answer while Keynes on inflation and debasement of the currency would appeal to even the most fervent of the Austrian school.

There seems to be a recurrent element of dogmatism dissernable in many proponents of the Austrian school. It seems ironic that every time Mises or Hayek is mentioned, every other idea or source of data is rejected on a fairly consistent, and predictable basis.

Just an observation.

"It's so incredible to me that so few free market economists are entirely unaware of this work, or Mises' magnum opus, Human Action."

This statement perfectly illustrates this point. It assumes that economists do not study Mises rather than consider the possibility that not all become converts.

 
At 12/23/2008 12:43 PM, Blogger QT said...

Marcus,

Thank you for a well argued post. Agree with your conclusion:

"I think Austrian theory is useful and descriptive of all this up to this point. That doesn't mean it explains everything."

Ed Glaeser is also worth a look on the subject of housing. He has done extensive research on urban economics with some interesting findings.

 
At 12/23/2008 12:54 PM, Blogger 1 said...

"Even Krugman can get the right answer while Keynes on inflation and debasement of the currency would appeal to even the most fervent of the Austrian school"...

Hmmm, I think not...

Both one of these towering economic intellects have one thing in common, they never asks, 'who pays?'...

 
At 12/23/2008 9:29 PM, Blogger the buggy professor said...

A suggestion, just in passing --- nothing more:

1) Instead of heady generalizations about Austrian or Keynesian theories --- accompanied in these exchanges by way too many insults or dismissals --- you might find the following two links at Post-Austrian Economics in the last couple of months. (Mark’s HTML won’t usually take “a href” tags for clicking on a link. You’ll need to copy the URL addresses and put them in the address bar of your browser).

http://post-austrianeconomics.blogspot.com/2008/12/in-response-to-paul-davidson.html

http://post-austrianeconomics.blogspot.com/2008/12/in-response-to-paul-davidson.html

,,,,,,,,,,,,,

2) Be sure to read the initial one first. It involves the similarities that Austrian economics has with traditional neo-classical mainstream economics in the late 19th and early 20th centuries . . . as argued by the leading Post-Keynesian radical theorist, Paul Davidson.

The second link entails a lengthy reply by Davidson, with several Austrian students and devotees commenting in the wake.

,,,,,,,,,,

3) A brief clarification about Post-Keynesianism now: Note first and foremost that it’s is not the same as New Keynesianism, which is embraced by most Keynesians these days --- such as Greg Mankiw or Paul Krugman.

* The New Keynesians are essentially inspired by a moderate interpretation of Keynes' work . . . which means they play down his stress on the great uncertainties that occur in markets, especially financial ones, in the recessionary periods of the business cycle.

* They also sidestep Keynes stress on animal spirits, not rational choices --- in any version, especially the rational-expectations twist that Robert Lucas of Chicago won a Nobel prize for a decade or so ago.

* Instead, they tend to hew close to New Classical free-market theories except to argue that money-wages tend to be rigid --- for good business reasons, a problem that leads to business firms laying off workers in a recession rather than reduce the wages of senior and other trained-personnel whose moral and loyalties they want to keep. On top of that, there are coordination problems that can show up in both the recessionary and boom phases of the business cycle.

* Hence they are for generally active monetary policies to deal with these problems . . . plus, reluctantly certainly in Mankiw's case), the use of fiscal stimuli other than tax cuts. The deeper the recession, the more they look to find multiplier effects to bring the overall economy back toward its long-term potential growth trend --- set by supply-side inputs: specifically, 1) the growth and quality of the labor force, 2) capital accumulation, and 3) growth in knowledge, whether embodied in machines as technologies or in more effective ways to organize and manage business and financial firms and market their products.

* The closer the economy is nudged by active fiscal or monetary policies (or both) to return to its long-term potential growth trend, the more it will, of course, move toward full employment . . . defined as the natural rate of employment (the rate an economy can sustain without setting off an inflationary spiral). New Keynesianism, then, accepts the Neo-Classical and New Classical updated version of an equilibrium tendency built into the free-market, which will ordinarily be maintained by ruled-based monetary policies without any need for fiscal stimuli.

……….

3) Paul Davidson is one of the leading radical Keynesians who call themselves Post-Keynesians.

They find the New Keynesianism wrong. They see it, rightly, rooted in efforts to turn Keynes into a variant of neo-classical free-market economics . . . the kind of Keynes whom Milton Friedman described as the first real modern monetarist theorist, and who also called Keynes General Theory of 1936 a "great book". (For the reference here, go to this link: http://en.wikipedia.org/wiki/John_Maynard_Keynes)

......

More to the point, Post-Keynesians find a more radical Keynes at the core of his work.

They stress that market economies aren't prone to general equilibrium (as do some, not all, Austrian economists --- though Davidson argues core-Austrian theory stresses this). They don't like the New Keynesian effort to merge with free-market theories except for the wage-rigidity problem and the possibly more serious coordination failures through price movements.

And they are much more prone to see financial markets, liquid assets, and the entire financial system as a key intermediary between supply and demand in the aggregate as leading --- via mass uncertainties in the minds of savers, investors, and business firms in recurrent manner during recessions --- to a coordination breakdown that can lead to prolonged recession and high unemployment . . . with, please note, no intrinsic market mechanism without active fiscal and monetary policies, for the market-economy by itself to return to some sort of long-term growth potential or equilibrium and hence full employment.

....

4) Against this background, you might find the exchanges between Davidson and the Austrians particularly suggestive. They have some things surprisingly in common, even as they disagree, of course, on the role of the government in market economies.

....

Michael Gordon, AKA, the buggy professor

P.S. Prof bug is not a post-Keynesian

 
At 12/24/2008 1:28 AM, Blogger OBloodyHell said...

> Here is a more detailed rebuttal of the Austrian theory by Krugman:

Hey, I was actually taking you halfway seriously until you attempted to use that idiot Krugman for justification of your assertion.

I grant Krugman might not be wrong in one or two rare instances, but that's not the way to bet. And anyone who quotes Krugman gets pretty close to an automatic write-off.

 
At 12/24/2008 11:24 AM, Blogger the buggy professor said...

After running my eye over the earlier buggy comment on "New Keynesianism" as opposed to the more radical "Post-Keynesian" school, I noticede an omission that is also at the core of the New Keynesian theories of a systematic market-failure that can cause deep recessions.

So . . . to the two causal problems that prevent a speedy, self-adjusting return of an economy in recession to its long-term growth potential --- set by supply side inputs of capital, labor, and new knowledge (including new technologies) --- add a third:

1) rigid money wages, built into the preference of business-firms to lay-off new and junior workers rather than undermine the morale and loyalties of their more senior, trained workers by reducing the wages of all their work-forces.


2) coordination problems across industries and within them . . . so that, say, a few firms that did reduce money wages (as well as laying off junior workers) would accentuate, possibly, the fall in the general price level. Such a deflationary drop in overall prices would keep the "real" wages of the workers whose money wages were cut the same, possibly, in purchasing power. It all depends. But one thing for sure: those workers in firms whose money wages weren't cut would enjoy an increase in real purchasing power.


3) Likewise, in inflationary periods, sooner or later increases in money wages for most of the work force will increase inflaltionary tendencies. Some firms, however, will raise their workers wages faster or earlier than others, and hence again there is a coordination problem --- these lucky workers will benefit initially from higher purchasing power.

These coordination problems lend themselves to game theory modeling.

...

4) The new problem now: menu-costs.

Essentially, lots of contracts between businesses and their suppliers or customers are set in specific past dollar-terms. It takes time and may be costly, aggravated by growing uncertainty if prices are rising or falling, to change them in line with new information about the relative prices in their industries.

Information and transaction costs are important obstacles to quick adjustments here.

.....

5) So what follows? On the New Keyensian view, two of these problems add up to serious rigidities in wages and prices that can be aggravated, further, by coordination problems. The overall result creates a set of uncertainties and delays in dislocated market economies from adjusting smoothly or quickly back to the long-term growth-potential of the economy and hence full-employment.

....

Michael Gordon, AKA, the buggy professor

 
At 12/24/2008 11:49 AM, Blogger the buggy professor said...

Here's a very good commentary on our current "Keynesian" moment amid our global credit-crunch and financial meltdown --- with the entire world moving into recession (at different rates) --- that was set out at the Financial Times by Martin Wolf . . . a talented economic journalist and a moderate in the theoretical battles between New Classical free-market devotees and New and Post-Keynesians.

Click here

It's easy to follow and takes in rightly the need for rebalancing the global system in two ways:

1) in the short-and-mid-term, try to persuade the perennial trade-surplus countries --- Germany, Japan, and China above all --- to join in with other countries in a large fiscal-stimuli set of policies.

2) And establish more effective global regulation and accountability to prevent the kind of crazy runaway financial chaos of the last decade, based on dubious and troubled financial instruments in derivative markets and sustained efforts to pass on risks in investments through a murky global chain of credit-swap flimflam.

......

Michael Gordon, AKA, the buggy professor

 
At 12/24/2008 12:29 PM, Blogger Michael Smith said...

Mach: My example of crashing commodity prices and CPI was no "emotional exhortation", it was to show you that there is no inflation. What prices are rising Michael Smith, because I would sure like to know and invest in that field?

You seem intent on making straw man arguments. I haven't said there are rising prices -- I’ve said there has not been a contraction of the money supply.

Mach: And I am not ignoring your explanation of deflation during the Great Depression. On the contrary, I believe the same is occurring right now. Deflationary forces are in control right now despite what the central bank is trying to do.

The bank failures that have occurred so far have not destroyed any fiduciary media because other banks have taken over those accounts. In the Great Depression, massive amounts of such fiduciary media disappeared. That was an actual deflation.

Here are the latest M2 numbers from the Federal Reserve (in billions of dollars):

2006 - December 7012.3
2007- January 7058.6
February 7084.8
March 7124.3
April 7173.9
May 7193.8
June 7210.4
July 7233.7
August 7286.1
September 7313.9
October 7338.3
November 7372.3
December 7404.3
2008 - Janauary 7448.9
February 7546.8
March 7618.1
April 7631.3
May 7640.7
June 7638.7
July 7679.5
August 7670.0
September 7769.1
October 7879.0
November 7936.4

No contraction there. It’s up 13.2% in 2 years.

Here is a link to the numbers:
Federal Reserve Statistical Release

Mach: And no, the central banks setting the rates to 0% and printing lots of money does not automatically imply inflation.

To the contrary, that is the very definition of inflation. Your problem is that you cannot grasp that the law of supply and demand means that factors other than the supply of money also affect prices.

However, there is one very good reason to worry about an *actual* deflation: the Fed has allowed our fractional reserve banking system to become preposterously over leveraged. Bank reserves right now are at less than 2%; that is, the cash they have on hand is only sufficient to cover 2% of their checking account deposits. That means that none of the banks could survive even a modest run.

So the Fed doesn't dare let the public lose confidence in the banking system. Trouble is, they don't know what the hell they are doing and all these interventions -- each bigger and different than the last intervention, and each one billed as the solution to our problems -- are serving to destroy our confidence in the system, not boost it.

Mach: As for you explanation of the global housing bubble, well at least you are getting a little closer to the truth. Blaming the central banks is a tiny bit more credible than blaming the CRA and I agree they do share in some of the blame by keeping rates too low for too long after the dotcom bubble burst and we can have a serious discussion whether all the blame lies in the central banks, but as long as you continue to blame the CRA this is not possible.

Oh, how charitable of you! If I’ll drop my claim that the CRA had a role in the housing bubble, then you’ll permit me to have a serious discussion! Why, it feels like Christmas!

If the CRA had no role in the housing bubble -- if it did not result in lender’s making riskier loans than they otherwise would, then why do we need it? Why are Democrats so determined to keep it in effect? You can quote all the regulators you want, but the fact remains that the Federal Housing Authority, the Federal National Mortgage Association, the Federal Home Loan Mortgage Association and the Community Reinvestment Act were all created to cause lenders to make riskier loans that they would otherwise make.

Mach: And again I repeat my questions from before. Why was there no credit/housing meltdown from 1977 to 2005?

The CRA didn’t really have much teeth until Clinton’s administration modified it.

Here are Janet Reno’s words from a speech give 3/20/98:

“The Community Reinvestment Act has played a critical part in ensuring that lending institutions put some of their capital into underserved areas, especially the inner cities and in minority neighborhoods.”

“You've noted that since the inception of our fair lending initiative in 1992 the Department has filed and settled 13 major fair lending lawsuits. We are going to continue these efforts under the Acting Assistant Attorney General Bill Lann Lee in every way that we possibly can. We will continue to focus on discrimination in underwriting, the process of evaluating the qualifications of credit applicants. This was the issue in our suits against Shawmut in Boston, Northern Trust Company in Chicago, and First National Bank of Donna Anna in New Mexico.”

You think banks and other lenders simply ignore a threat from the Attorney General of the United States to continue filing lawsuits against those she deems to be “under serving” some particular minority?

Mach: “Why did 30 other countries, none of which have are covered by the CRA, have a remarkably similar housing boom and bust to the USA?”

Objection! Asked and answered!

 
At 12/24/2008 1:07 PM, Blogger QT said...

"Bank reserves right now are at less than 2%; that is, the cash they have on hand is only sufficient to cover 2% of their checking account deposits."

Michael,

A most interesting statement. Do you have a link to support this?

Under the international banking rules (Basel II), capital requirements were increased for conventional loans and mortgages several years ago however, the capital requirements did not apply to mortgages held in the form of securities. Perversely, regulations intended to strengthen the international banking system have encouraged securitization and leveraging. (ie. make loans, bundle loans into securities, sell the securities, loan the money...etc.)

Once someone questioned the underlying value of the securities, the market for securitized mortgages disappeared overnight. Many of the mortgages were made by mortgage brokers rather than banks and it is difficult to establish the value of the assets. If the bank takes them bank on the balance sheet, capital must be set aside.

It really depends upon how one classifies the assets as to whether the capital requirements are being met or not. My understanding is that much of the securitization activities were carried out by investment banks which don't have regular depositors. These investment banks had leverage rates as high as 30-1 and did sell their securities to commercial banks. Fred & Fan were also engaged in securitization and apparently had even higher leverage rates according to this presentation from the Milken Institution. The Milken presentation has a lot of information on the credit meltdown that is of interest.

Would appreciate any information you have on the present capital situation of commercial banks.

Thanks. Have a great Christmas.

 
At 12/25/2008 10:43 AM, Blogger Michael Smith said...

QT:

My data originally came from this article by economist George Reisman: Our Financial House of Cards Go down to paragraphs 31 - 32 if you don’t want to read the whole article.

That article is from last March, so admittedly the data is old. At the time, I was shocked at such low reserves -- only $40 billion according to Reisman‘s article. But I went to a Federal Reserve website and it showed the same thing.

However, if you check the reserve situation right now, it shows that total reserves have taken a huge, HUGE leap, starting in September. Non-borrowed reserves actually went negative for most of 2008, apparently only going positive in the last couple of weeks. Here is the data: Fed Data Release

I don’t know what to make of that data, except to say that while $800 billion in reserves is a lot safer than $40 billion, I'm sure "helicopter Ben's" intent wasn't for the banks to sit on that money.

By the way, thanks for the link to the Milken presentation. Very interesting.

 

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