The problem with this kind of thinking, that it's all about replacing lost demand, is that it's a grotesque oversimplification of what an economy is.

TO BE NOTED: From Clusterstock:

"Robert Reich's Dangerously Simplistic Economic View (VIDEO)

Joe Weisenthal|Apr. 3, 2009, 12:39 PM|26

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Tags: Economy, Financial Crisis, Stimulus

Larry Kudlow's favorite liberal economist Robert Reich appeared on CNBC, defending the Obama budget and the gigantic debt we're building up (video below).

His argument: There's simply no other way to get the economy going again than for the government to fill in the lost private demand. In other words, since consumers and businesses have stopped spending, the government has to step in, even if it means debt as far as they eye can see.

The problem with this kind of thinking, that it's all about replacing lost demand, is that it's a grotesque oversimplification of what an economy is. The economy isn't just a simple formula that has DEMAND on one end and GROWTH and JOBS coming out.

Robert Higgs at the Independence Institute busted this idea in a recent article. The whole thing is worth a read, but here's the nut:

This way of compressing diverse, economy-wide transactions into single variables has the effect of suppressing recognition of the complex relationships and differences within each of the aggregates. Thus, in this framework, the effect of adding a million dollars of investment spending for teddy-bear inventories is the same as the effect of adding a million dollars of investment spending for digging a new copper mine. Likewise, the effect of adding a million dollars of consumption spending for movie tickets is the same as the effect of adding a million dollars of consumption spending for gasoline. Likewise, the effect of adding a million dollars of government spending for children’s inoculations against polio is the same as the effect of adding a million dollars of government spending for 7.62 mm ammunition. It does not take much thought to conceive of ways in which suppression of the differences within each of the aggregates might cause our thinking about the economy to go seriously awry.

In fact, “the economy” does not produce an undifferentiated mass we call “output.” Instead, the millions of producers who bring forth “aggregate supply” provide an almost infinite variety of specific goods and services that differ in countless ways. Moreover, an immense amount of what goes on in a market economy consists of dealings among producers who supply no “final” goods and services at all, but instead supply raw materials, components, intermediate products, and services to one another. Because these producers are connected in an intricate pattern of relations, which must assume certain proportions if the entire arrangement is to work effectively, critical consequences turn on what in particular gets produced, when, where, and how.

These extraordinarily complex micro-relationships are what we are really referring to when we speak of “the economy.” It is definitely not a single, simple process for producing a uniform, aggregate glop. Moreover, when we speak of “economic action,” we are referring to the choices that millions of diverse participants make in selecting one course of action and setting aside a possible alternative. Without choice, constrained by scarcity, no true economic action takes place. Thus, vulgar Keynesianism, which purports to be an economic model or at least a coherent framework of economic analysis, actually excludes the very possibility of genuine economic action, substituting for it a simple, mechanical conception, the intellectual equivalent of a baby toy.

Read the whole >

In the end, it's not spending or supply or demand or jobs that define a healthy economy. It's the ability for humans in this complex human network to work together to create value that defines health. No amount of spending or "priming the pump" will do the trick if the network is broken.

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the portrayal by contemporary models of the “market economy as a mechanical system.”

TO BE NOTED: From the Economist's View:

"Mathematical Formalism in Economics

Roman Frydman responds to the response to the Anatole Kaletsky article, Goodbye, homo economicus:

Your posting of Kaletsky’s article has led to a much overdue discussion of the usefulness of mathematical formalism for understanding market outcomes. This is particularly important as the recent discussions of failures of economic models have focused on specific assumptions, such as incompleteness of markets, contracts or nonlinearities (Willem Buiter), or neo-Keynesian versus new classical approaches (Paul Krugman).

The attached note, which draws heavily on my recent book and subsequent papers with Michael Goldberg, argues that the question of whether and what type of mathematical formalism can help us understand market outcomes in modern capitalism is more subtle than Kaletsky’s critics might have realized.

Here's the note:

What type of mathematical formalism can help us understand market outcomes in modern capitalism?

Mark Thoma reports that the article by Anatole Kaletsky Goodbye, homo economicus, calling for an intellectual revolution in economics, “did not get the best reception here and elsewhere, and there were also protests that arrived by email.”

What really irked Kaletsky’s antagonists was his attack on the use of mathematical formalism in economics. But what has gone completely unnoticed in the subsequent discussion is that Kaletsky’s attack on mathematical formalism focused not on the use of mathematics in economics as such, but on the portrayal by contemporary models of the “market economy as a mechanical system.”

This characterization of contemporary macro and finance models seems uncontroversial. Regardless of whether these models are based on REH or behavioral considerations, they represent the causal mechanisms that supposedly underpin change on individual and aggregate levels through mechanical rules. Thus, they ignore the key feature of modern economies: the fact that individuals and companies engage in innovative activities, discovering new ways of using existing physical and human capital and technology, as well as new technologies and new capital in which to invest.

Moreover, the institutions and the broader social context within which this entrepreneurial activity takes place also change in novel ways. Innovation in turn influences future returns from economic activity in ways that no one, including economists, and market participants, can fully foresee, and thus that do not conform to any rule that can be prespecified in advance.

In our recent book, Imperfect Knowledge Economics (IKE), Michael Goldberg and I trace the empirical failures and fundamental epistemological flaws within the contemporary models of “rational” or “irrational” behavior to a common source: in modeling aggregate outcomes, contemporary economists fully prespecify the causal mechanism that underpins change in real-world markets.

To remedy this flaw, IKE jettisons mechanical models of change and attempts to construct economic models of individual behavior and aggregate outcomes on the basis of qualitative regularities that can be formalized with mathematical conditions. An aggregate model based on such micro-foundations generates only qualitative predictions of market outcomes.

This brings us back to the key question: whether, and if so, some mathematical formalism might be useful in our quest to understand individual behavior and market outcomes.

In our recent paper, Macroeconomic Theory for a World of Imperfect Knowledge, Goldberg and I show that the answer to this question may lie in the non-standard use of probabilistic formalism.

Our article has an extensive formal analysis of what this might entail and what it implies both theoretically and empirically. However, for the reader who is interested in a quick overview, it might be useful to reproduce one section (4.1.1.) of our article that does so more informally. The paragraphs that follow discuss how IKE explores the middle ground between Knight’s and Keynes’s arguments against the use of standard probability theory in economic analysis and contemporary reliance on models that generate “sharp predictions”: one “overarching” probability distribution, which is presumed to adequately capture market outcomes, past and future.

Contemporary models represent outcomes at each point in time -- and thus how they unfold over time -- with a single "overarching" conditional probability distribution. The relationships between the moments of this distribution and the set of causal variables constitute the model's empirical content that can be confronted with the time-series data.

By contrast, early modern economists argued that standard probabilistic representations cannot adequately represent change. Indeed, both Frank Knight and John Maynard Keynes emphasized that economic decisions and institutional and policy changes are fraught with radical uncertainty; the complete set of outcomes and their associated probabilities can neither be inferred from past data nor known in advance.

Radical uncertainty is often thought of as a situation in which no economic theory is possible: neither economists (nor market participants) are able to represent mathematically any aspects of the causal mechanism underpinning change. IKE adopts an intermediate position between radical uncertainty and the contemporary presumption that models that fully prespecify change are not only within reach of economic analysis, but anything less is not worthy of scientific status.

Of course, if economic decisions stem only from erratic "animal spirits," no economic theory is possible. As Edmund Phelps recently put it, "animal spirits can't be modelled." Although animal spirits may play a role, IKE explores the possibility that individual decision-making displays some qualitative regularity that can be represented with a mathematical model.

Departing from the position of Knight and Keynes, IKE makes use of probabilistic formalism. This facilitates the formalization of conditions that specify the microfoundations of IKE models and the mathematical derivation of their qualitative implications. However, IKE recognizes the importance of early modern arguments that market participants, let alone economists, have access to only imperfect knowledge of which causal factors may be useful for understanding outcomes and how they influence those outcomes.

Like extant approaches, IKE represents revisions of market participants' forecasting strategies, and more broadly change in how individuals make decisions, with transitions across probability distributions. But IKE constrains these revisions with qualitative conditions only. Consequently, it does not follow extant approaches in presuming that individual decision making and market outcomes can be adequately represented with a single overarching probability distribution. At the same time, IKE does not adopt the other extreme position that uncertainty is so radical as to preclude economists from saying anything useful and empirically relevant about how market outcomes unfold over time.

Because its restrictions on change are qualitative, IKE models represent outcomes at every point in time with myriad probability distributions. Nevertheless, the qualitative restrictions of IKE models constrain all transitions across probability distributions to share one or more qualitative features. These common features, which are embodied in what we call partially predetermined probability distributions, enable economists to model mathematically some aspects of the causal mechanism that underpin individual decision making and market outcomes. Such probabilistic representations constitute the empirical content of IKE models.

Although IKE acknowledges the limits to knowledge, it constrains its models sufficiently to distinguish empirically among alternative explanations of aggregate outcomes. In our book, we develop several alternative IKE models and show that their qualitative predictions enable us to reject some in favor of others on the basis of time-series data. Jettisoning sharp predictions may appear to lower the "scientific standard" that economists have self-imposed on their models. But as Friedrich Hayek anticipated, replacing the "pretense of exact knowledge" with imperfect knowledge as the foundation for economic analysis is crucial for understanding markets. Remarkably, stopping short of sharp predictions is also necessary to escape the epistemological flaws of extant fully predetermined models.”

In our book, we show how IKE models shed new light on the salient features of the empirical record on exchange rates, which have confounded international macroeconomists for decades. In part III of Macroeconomics for a World of Imperfect Knowledge, Michael and I sketch our methodology and show how it can be applied to study price movements in other asset markets. Although these results are promising, it is much too early to claim broader usefulness for IKE in macroeconomic and policy modeling.

Moreover, our discussion reveals that the question as to whether mathematical formalism may help us understand economic phenomena is more subtle than Kaletsky’s critics might have realized. As Kaletsky points out, early modern economists relied on a largely narrative mode of analysis. Although imprecise by contemporary standards, narrative accounts had the important advantage of leaving economists relatively free to explore the complexity and opaqueness of the interdependence between individual rationality, the social context of decision-making, and market outcomes. (Of course, a narrative mode of analysis also constrains argument, but this constraint is relatively weak compared to the rigor of mathematical language.)

Indeed, the giants of early modern economics uncovered remarkably powerful and durable insights, such as Hayek's prescient prediction that socialist planning is bound in principle to fail; Knight's assertion that standard probabilistic uncertainty cannot adequately characterize business decisions; and Keynes's closely related arguments concerning the importance of radical uncertainty, the social context, and conventions for forecasting returns and risk on investment in real and financial assets. These insights point to the fundamental flaw in the research program of contemporary economists: the causal mechanism that underpins change in capitalist economies is not completely intelligible to anyone, including market participants, economists, policy officials, or social planners.

In contrast to the conventional approach, which seeks to understand economic decisions with universal mechanistic rules, the constraints of IKE models are qualitative and context dependent. If qualitative regularities can be established in contexts other than asset markets, IKE can show how they can be incorporated into mathematical models. But in contexts in which change cannot be adequately characterized with reasonably long-lasting qualitative conditions, empirically relevant models of the observed time-series may be beyond the reach of economic analysis. In this sense, IKE provides the boundary to what modern macroeconomic theory --- which aims to explain empirical regularities in aggregate outcomes with models that are based on mathematical microfoundations --- can deliver."

"For Schumpeter, there was something both noble and tragic about the spirit of capitalism."

Robert Skidelsky in the Guardian:

"Testifying recently before a United States congressional committee, former Federal Reserve chairman Alan Greenspan said that the recent financial meltdown had shattered his "intellectual structure". I am keen to understand what he meant.

Since I have had no opportunity to ask him, I have to rely on his memoirs, The Age of Turbulence, for clues. But that book was published in 2007 – before, presumably, his intellectual structure fell apart.

In his memoirs, Greenspan revealed that his favorite economist was Joseph Schumpeter, inventor of the concept of "creative destruction"( ALL THIS MEANS IS THAT BUSINESSES COME AND GO. IT IS NOT PROFOUND. ). In Greenspan's summary of Schumpeter's thinking, a "market economy will incessantly revitalise itself from within by scrapping old and failing businesses and then reallocating resources to newer, more productive ones". Greenspan had seen "this pattern of progress and obsolescence repeat over and over again".

Capitalism advanced the human condition, said Schumpeter, through a "perennial gale of creative destruction", which he likened to a Darwinian process of natural selection to secure the "survival of the fittest"( A VERY BAD ANALOGY. BUT COMMON. ). As Greenspan tells it, the "rougher edges" of creative destruction were legislated away by Franklin Roosevelt's New Deal, but after the wave of de-regulation of the 1970s, America recovered much of its entrepreneurial, risk-taking ethos. As Greenspan notes, it was the dot-com boom of the 1990s that "finally gave broad currency to Schumpeter's idea of creative destruction".

This was the same Greenspan who in 1996 warned of "irrational exuberance" and, then, as Fed chairman, did nothing to check it. Both the phrase and his lack of action make sense in the light of his (now shattered) intellectual system.

It is impossible to imagine a continuous gale of creative destruction taking place except in a context of boom and bust. Indeed, early theorists of business cycles understood this. (Schumpeter himself wrote a huge, largely unreadable, book with that title in 1939.)

In classic business-cycle theory, a boom is initiated by a clutch of inventions – power looms and spinning jennies in the 18th century, railways in the 19th century, automobiles in the 20th century. But competitive pressures and the long gestation period of fixed-capital outlays multiply optimism, leading to more investment being undertaken than is actually profitable. Such over-investment produces an inevitable collapse. Banks magnify the boom by making credit too easily available, and they exacerbate the bust by withdrawing it too abruptly. But the legacy is a more efficient stock of capital equipment.

Dennis Robertson, an early 20th-century "real" business-cycle theorist, wrote: "I do not feel confident that a policy which, in the pursuit of stability of prices, output, and employment, had nipped in the bud the English railway boom of the forties, or the American railway boom of 1869-71, or the German electrical boom of the nineties, would have been on balance beneficial to the populations concerned." Like his contemporary, Schumpeter, Robertson regarded these boom-bust cycles, which involved both the creation of new capital and the destruction of old capital, as inseparable from progress.

Contemporary "real" business-cycle theory builds a mountain of mathematics on top of these early models, the main effect being to minimise the "destructiveness" of the "creation". It manages to combine technology-driven cycles of booms and recessions with markets that always clear (ie there is no unemployment).

How is this trick accomplished? When a positive technological "shock" raises real wages, people will work more, causing output to surge. In the face of a negative "shock", workers will increase their leisure, causing output to fall.

These are efficient responses to changes in real wages. No intervention by government is needed. Bailing out inefficient automobile companies such as General Motors only slows down the rate of progress. In fact, whereas most schools of economic thought maintain that one of government's key responsibilities is to smooth the cycle, "real" business-cycle theory argues that reducing volatility reduces welfare!

It is hard to see how this type of theory either explains today's economic turbulence, or offers sound instruction about how to deal with it. First, in contrast to the dot-com boom, it is difficult to identify the technological "shock" that set off the boom. Of course, the upswing was marked by super-abundant credit. But this was not used to finance new inventions: it was the invention( ONE COULD ARGUE THIS ). It was called securitised mortgages. It left no monuments to human invention, only piles of financial ruin.

Second, this type of model strongly implies that governments should do nothing in the face of such "shocks". Indeed, "real" business-cycle economists typically argue that, but for Roosevelt's misguided New Deal policies, recovery from the Great Depression of 1929-1933 would have been much faster than it was.

Equivalent advice today would be that governments the world over are doing all the wrong things in bailing out top-heavy banks, subsidising inefficient businesses, and putting obstacles in the way of rational workers spending more time with their families or taking lower-paid jobs. It reminds me of the interviewer who went to see Robert Lucas, one of the high priests of the New Business Cycle school, at a time of high American unemployment in the 1980s.
"My driver is an unemployed PhD graduate," he said to Lucas. "Well, I'd say that if he is driving a taxi, he's a taxi-driver," replied the 1995 Nobel laureate.

Although Schumpeter brilliantly captured the inherent dynamism of entrepreneur-led capitalism, his modern "real" successors smothered his insights in their obsession with "equilibrium" and "instant adjustments". For Schumpeter, there was something both noble and tragic about the spirit of capitalism. But those sentiments are a world away from the pretty, polite techniques of his mathematical progeny."

I have to say that Schumpeter's world view was not close to mine. It was tragic, but more like the Eternal Return of Nietzsche. The current Mechanistic Economics is a melange of slightly useful theories and models. Nothing more.

"These efforts, akin to avoiding bank runs in prior periods"

Robert Barro in the WSJ:

"Back in the 1980s, many commentators ridiculed as voodoo economics the extreme supply-side view that across-the-board cuts in income-tax rates might raise overall tax revenues. Now we have the extreme demand-side view that the so-called "multiplier" effect of government spending on economic output is greater than one -- Team Obama is reportedly using a number around 1.5.

To think about what this means, first assume that the multiplier was 1.0. In this case, an increase by one unit in government purchases and, thereby, in the aggregate demand for goods would lead to an increase by one unit in real gross domestic product (GDP). Thus, the added public goods are essentially free to society. If the government buys another airplane or bridge, the economy's total output expands by enough to create the airplane or bridge without requiring a cut in anyone's consumption or investment.

The explanation for this magic is that idle resources -- unemployed labor and capital -- are put to work to produce the added goods and services.

If the multiplier is greater than 1.0, as is apparently assumed by Team Obama, the process is even more wonderful. In this case, real GDP rises by more than the increase in government purchases. Thus, in addition to the free airplane or bridge, we also have more goods and services left over to raise private consumption or investment. In this scenario, the added government spending is a good idea even if the bridge goes to nowhere, or if public employees are just filling useless holes. Of course, if this mechanism is genuine, one might ask why the government should stop with only $1 trillion of added purchases.( THIS IS TRUE )

What's the flaw? The theory (a simple Keynesian macroeconomic model) implicitly assumes that the government is better than the private market at marshaling idle resources to produce useful stuff( ONLY IN AN ECONOMIC CRISIS ). Unemployed labor and capital can be utilized at essentially zero social cost, but the private market is somehow unable to figure any of this out( THE FEAR AND AVERSION TO RISK IS NOT RATIONAL ). In other words, there is something wrong with the price system.( THERE IS. FEAR AND AVERSION TO RISK. )

John Maynard Keynes thought that the problem lay with wages and prices that were stuck at excessive levels. But this problem could be readily fixed by expansionary monetary policy, enough of which will mean that wages and prices do not have to fall( WE SHOULD DO THIS ). So, something deeper must be involved -- but economists have not come up with explanations, such as incomplete information, for multipliers above one.

A much more plausible starting point is a multiplier of zero. In this case, the GDP is given, and a rise in government purchases requires an equal fall in the total of other parts of GDP -- consumption, investment and net exports( NOT IN A CALLING AND PROACTIVITY RUN ). In other words, the social cost of one unit of additional government purchases is one.

This approach is the one usually applied to cost-benefit analyses of public projects. In particular, the value of the project (counting, say, the whole flow of future benefits from a bridge or a road) has to justify the social cost. I think this perspective, not the supposed macroeconomic benefits from fiscal stimulus, is the right one to apply to the many new and expanded government programs that we are likely to see this year and next.( HERE I COMPLETELY AGREE )

What do the data show about multipliers? Because it is not easy to separate movements in government purchases from overall business fluctuations, the best evidence comes from large changes in military purchases that are driven by shifts in war and peace. A particularly good experiment is the massive expansion of U.S. defense expenditures during World War II. The usual Keynesian view is that the World War II fiscal expansion provided the stimulus that finally got us out of the Great Depression. Thus, I think that most macroeconomists would regard this case as a fair one for seeing whether a large multiplier ever exists.

I have estimated that World War II raised U.S. defense expenditures by $540 billion (1996 dollars) per year at the peak in 1943-44, amounting to 44% of real GDP. I also estimated that the war raised real GDP by $430 billion per year in 1943-44. Thus, the multiplier was 0.8 (430/540). The other way to put this is that the war lowered components of GDP aside from military purchases. The main declines were in private investment, nonmilitary parts of government purchases, and net exports -- personal consumer expenditure changed little. Wartime production siphoned off resources from other economic uses -- there was a dampener, rather than a multiplier.( ONE COULD ARGUE THAT THE WAR, BEING A WAR, EFFECTED PEOPLE'S ATTITUDES IN ANY NUMBER OF WAYS. )

We can consider similarly three other U.S. wartime experiences -- World War I, the Korean War, and the Vietnam War -- although the magnitudes of the added defense expenditures were much smaller in comparison to GDP. Combining the evidence with that of World War II (which gets a lot of the weight because the added government spending is so large in that case) yields an overall estimate of the multiplier of 0.8 -- the same value as before. (These estimates were published last year in my book, "Macroeconomics, a Modern Approach.")

There are reasons to believe that the war-based multiplier of 0.8 substantially overstates the multiplier that applies to peacetime government purchases. For one thing, people would expect the added wartime outlays to be partly temporary (so that consumer demand would not fall a lot( THAT DOESN'T FOLLOW. A WAR COULD IN FACT DAMPEN DEMAND BY EFFECTING HUMAN BEHAVIOR. ). Second, the use of the military draft in wartime has a direct, coercive effect on total employment. Finally, the U.S. economy was already growing rapidly after 1933 (aside from the 1938 recession), and it is probably unfair to ascribe all of the rapid GDP growth from 1941 to 1945 to the added military outlays. In any event, when I attempted to estimate( THAT'S ALL YOU DID ) directly the multiplier associated with peacetime government purchases, I got a number insignificantly different from zero.

As we all know, we are in the middle of what will likely be the worst U.S. economic contraction since the 1930s. In this context and from the history of the Great Depression, I can understand various attempts( YES ) to prop up the financial system. These efforts, akin to avoiding bank runs in prior periods( YES. THAT'S WHY I CALL THEM A CALLING RUN AND A PROACTIVITY RUN. ), recognize that the social consequences of credit-market decisions extend well beyond the individuals and businesses making the decisions.

But, in terms of fiscal-stimulus proposals, it would be unfortunate if the best Team Obama can offer is an unvarnished version of Keynes's 1936 "General Theory of Employment, Interest and Money." The financial crisis and possible depression do not invalidate everything we have learned about macroeconomics since 1936.

Much more focus should be on incentives for people and businesses to invest, produce and work. On the tax side, we should avoid programs that throw money at people and emphasize instead reductions in marginal income-tax rates -- especially where these rates are already high and fall on capital income. Eliminating the federal corporate income tax would be brilliant( TARGETED TOWARDS INVESTMENT. ). On the spending side, the main point is that we should not be considering massive public-works programs that do not pass muster from the perspective of cost-benefit analysis( I AGREE ). Just as in the 1980s, when extreme supply-side views on tax cuts were unjustified, it is wrong now to think that added government spending is free."

I'm beginning to realize that economists are using preposterous views of Human Agency as a matter of course. Wars can have a myriad of effects, and simply assuming that, if they don't last long, consumption will remain the same, seems totally unjustified to me. Much depends on the nature and context of the war. Barro sees people as robots. I don't. One reason economics is so useless to us is its use of and reliance on Mechanistic Explanations.

Still, his recommendations are like mine. One reason is that I believe that the focus on the amount of the stimulus is also a mechanistic explanation. Tax incentives are a Human Agency approach. Spending money on a cost-benefit basis is more like common sense and fiscal prudence. There is some sense in government spending when investors are frozen by the fear and aversion to risk. However, the spending should still be prudent and wise. It should not mechanistically be spent in order to hit an artificial target.

"what I consider to be a plausible range of economic outcomes is, at the moment, quite wide indeed"

From Felix Salmon:

"Can We Really Guide the Economy?

Ryan Avent says that he thinks the "plausible range of economic outcomes is, at the moment, quite wide indeed", and wonders whether "the size of this conceivable range is actually reflective of potential outcomes, rather than simple ignorance":

If it seems like things could go really well or really poorly, is it because outcomes are very dependent on our actions( TRUE ) or because we have no idea what's going on( BOTH ARE TRUE )? And I suppose that if you want to understand the different approaches to policy advocated by liberals relative to libertarians, that question, and its answer, is key( HOW SO? ).

The easy answer is that this is not "simple ignorance". Studies have shown repeatedly and convincingly that the range of possible outcomes is nearly always greater than you think, not smaller. Economically speaking, actual results regularly come out quite far away from even pretty near-term forecasts, which is one reason why asking economists (or journalists, for that matter) to predict when we're going to come out of recession is an exercise in futility( I AGREE ).

On the other hand, that doesn't necessarily mean that outcomes are very dependent on our actions. What action, for instance, did we take to send the price of oil plunging by $100 a barrel in the space of a few short months? That's the kind of thing which can only happen in a highly complex and therefore wholly unpredictable system( TRUE ).

So I don't think of liberals' policy approach as being deterministic( MECHANISTIC ) -- if we do this, then the economy will do that. Instead, I think of it as working the other way around: if the economy does this, then we should do( TRY ) that. Right now, the economy is tanking( A PROACTIVITY RUN), and so we should apply a large dose of stimulus( SPENDER OF LAST RESORT ). We can't predict with any accuracy what the results will be, but there's a very high chance that they will be better than if we did nothing( WE CAN'T DO NOTHING. A PROACTIVITY RUN NEEDS TO BE STOPPED BECAUSE THERE IS NO WAY OF TELLING HOW MUCH WEALTH COULD BE LOST OR HOW MANY JOBS COULD BE LOST UNTIL IT ENDS ON ITS OWN. WE CAN'T CHANCE THAT CATASTROPHIC OF A POSSIBILITY, WHICH COULD LEAD TO SERIOUS SOCIAL DISLOCATIONS AND DISRUPTIONS. ONLY THE GOVERNMENT HAS THE RESOURCES BEHIND IT STAND UP TO A CALLING OR PROACTIVITY OR BANKING RUN IN THIS AGE. NO OTHER INTERVENTION WOULD BE BELIEVED SUFFICIENT TO STOP THE RUN. )., which is the default libertarian position."

Here's Avent on The Bellows:

"Knife Edge

• Posted by ryan on January 8th, 2009 filed in Economics, Miscellany
• 
  

Watching Obama’s speech, it occurred to me that what I consider to be a plausible range of economic outcomes is, at the moment, quite wide indeed( I AGREE ). I can envision scenarios in which recovery is fairly rapid, believe it or not( THIS IS MY POSITION ). A number of economic statistics were trending positively toward late summer of last year — before the dramatic intensification of the financial crisis laid waste to the economy. If we’re able to get banks functioning again, then a quick, large stimulus might jolt us rapidly back to something near trend growth. I can also imagine some very dire scenarios, many of which involve instability abroad and negative feedback loops to the global economic system( VERY TRUE )."

I see Mechanistic Thinking in terms of the Democratic proposals in the specificity of the amounts chosen. In other words, if we plug in this number, this will be the consequence. The usual reason seems to be that we want to replace a recent consumption figure or some number like that. I don't see the problem that way at all. To me, the stimulus is intended to stop the Proactivity Run. The amount we should spend should be enough to accomplish that, as best we can tell. It might be more than some people want or less than some people want in the end. The stimulus should be spent over two years in order to assess how it is functioning. Otherwise, why not just spend enough money to happily employ everyone. Obviously there's a limit to the sense of this amount. As well, the amount we spend could have adverse consequences by spooking our creditors. Prudence here is necessary, as well as speed. Getting bogged down in debating the enormity of the eventual size of the stimulus doesn't seem wise to me.

"the current punditry will be seen as a silly and damaging exercise in talking down confidence"

From the Guardian, a perspective akin to mine:

"For all the wild apocalyptic punditry, recessions pass. This one will, too

Where economists fail, bishops, philosophers and gurus rush foolishly in. Despite them, we will muddle through again ( THAT'S IT )

Comments (19)

• 
• • Simon Jenkins
  • The Guardian, Friday 9 January 2009
  • Article history

So we are doomed. The boffins have tried everything yet the disease rages unchecked. Economists are retreating from the recessionary front, wild-eyed and covered in blood. The public has recourse to others, to soothsayers and purveyors of prayers, jujus and magic mushrooms. They are having a field day.

The historians are leaping up and down, warbling that things are "the worst since", variously, 1992 or 1981 or the 70s or the 30s. It is like climatologists warning that a particular year is the hottest (or coldest) since a previous one was even hotter or colder. Circumstances are never different. History obeys Occam's law of simplicity.

The Marxists are ecstatic. Eric Hobsbawm has returned from the ideological grave to declare "the greatest crisis of capitalism since the 1930s" and the dramatic equivalent of the fall of the Soviet Union, hardly a precedent he should recall. The website permanentrevolution.com is awash in glee. "So much for marginal utility theory and neoconservatism," cries Bill Jefferies.

The "affluenza" guru, Oliver James, is unequivocal. From the security of a successful career he declares that wealth only drives us mad. "One of the great boons of the sudden collapse of neoliberalism," he says, "is that needs will no longer be conflated with wants." Such Marxist terminology should put an end to most of the British manufacturing and service industry. People, says James, should now spend more time with their families and "rediscover their hobbies, such as sports, stamp-collecting and trainspotting".

Long-wave theorists are back in fashion. Millenarians see the dawn of a new class struggle, in which the masses rise up and shake off their oppressive capitalist debts, like bankrupt African dictators.

Philosophers are no less barmy. The normally sane AC Grayling declares the credit crunch a "classic display of non-rational behaviour", ignoring the essence of financial bubbles, that they result from individuals behaving rationally in the short-term, but without adequate regulation to marry short to long( I AGREE WITH GRAYLING HERE ). Debt mountains may be motivated by love of money, but economies depend on postponed gratification, on profitable saving, to grow. Not Marx but Niebuhr( READ THEM BOTH IN ORDER TO BE EDUCATED ) is needed to police this boundary between "moral man and immoral society".

Grayling has one solution, to his credit. He has come across a hormone called oxytocin. Administered nasally, it is said "in tests" to double the level of trust between game players. The government should therefore line up all bankers and spray oxytocin up their noses. As a policy it could hardly be worse than spraying them with money. This is upstaged by a van spotted in London advertising "dial-a-philosopher", a 24-hour emergency on-call service "to deal with your existential angst at a moment's notice". The advice to sufferers in the credit crunch is "don't even think about it, call us". The service is available only inside the M25, and presumably as of April 1.

Bishops are having an even better time. When a crisis is a total mystery, the mystifiers are in a state of grace. A ban has presumably been put on the parable of the talents (a servant castigated by Christ for saving rather than investing). The Church of England feels we had it coming to us, though it unfortunately omitted to warn us beforehand. We are duly doomed for our debt and greed.

The Bishop of Manchester declares the "collapse of the god of materialism and consumerism" (a deity unknown to me) and its replacement by a god who apparently will "force us to think again". The bishop is clearly a polytheist.

Cardinal Cormac Murphy-O'Connor is adamant that "the market economy will only work justly if it has an underlying moral purpose", a redundancy if ever I saw one. As for the Archbishop of Canterbury, he seems in a perpetual state of despair. We must not, he said at Christmas, go the way of Hitler. Quite so.

Last week the BBC curiously allowed a handful of celebrities to hijack its Today programme to boost themselves, their businesses and their favourite charities. One hilarious nugget was an interview in which the boss of Citibank, Sir Win Bischoff, interviewed an Olympic cyclist on what cycling could teach banking. Amid the waffle there was no mention of what had maintained both individuals in 2008: truly stupefying amounts of taxpayers' money. There was not so much as a thank you.

The belief in the virtues of a hair shirt, but not on my own back, is embedded in Britain's puritanical establishment. It believes that, since the poor in some sense deserved recession, nasty medicine will be good for their collective soul. The bursting of the housing bubble, so liberally pumped by politicians, is taken to prove the sin of plebeian greed. The fact that every policymaker is straining every muscle to find a way back to wealth from recession suggests that hair shirts have yet to acquire political traction. That does not stop the moral pundits.

Just as Christmas is a time to be jolly and April Fools' Day to be silly, perhaps a week should be set aside for completely daft remarks about the economy. Cardinals can demand moral markets. Prime ministers can take people's money and shower it on banks. Peter Mandelson can declare himself content with the institutional embezzlement of bonuses. Yvette Cooper can declare getting on the housing ladder "a right and a necessity" for every young person. The Bishop of Reading can advocate "putting the waiting back into wanting", just when the economy needs us to spend for dear life.

I have no idea what is going to happen over the coming year and nor does anyone else. The futurology game has been shot to ribbons, making fools of everyone. Economic forecasting has collapsed in ignominy and if there were any justice the profession would be sacked en masse. Nostradamus would do a better job than Alistair Darling's lot.

The only recourse is to history( FOR NARRATIVE THINKING ). History teaches that all recessions end, when people resume spending and when businesses can start borrowing against that spending. When this happens, as it will, we shall forget that 2008 marked the end of Thatcherism or the collapse of capitalism or the dawn of socialism. The cobblers will return to their lasts.

As it is, house prices are still not back to where they were at the start of the decade. Unemployment, admittedly a flexible concept, is not back to its level of 20 years ago. The third of the workforce on protected government wages or pensions are safe from sorrow - and presumably still spending.

At the time of the three-day week in 1974, which on any measure of tolerability was worse than today, a retired colonel wrote to the Times deploring the gloom then rife in the paper's columns. To be sure, Britain was stricken with strikes, power cuts and unemployment. It was widely thought to be ungovernable and possibly on the brink of revolution. But come on, said the colonel, Britain would do what it had always done. It would "muddle through ... yours faithfully".

It did. Likewise the present crisis will pass and the current punditry will be seen as a silly and damaging exercise in talking down confidence. But that spoils the fun."

I tend to agree with him that, as of now, things aren't as bad as in the past. However, surely this crisis has taught us not to count on history or anything else. I notice that he picked positive historical events, not negative ones. Apparently, he believes that revolutions and social disruptions are things of the past. I do hope so, but to count on that is silly. Also, there's nothing wrong with talking about morals and what this crisis means, but it does seem like some people are reading rather too much into this crisis, as if they've been praying for its occurrence for years.

In saying that many people have gone overboard and Marxism is bunk, it doesn't help to trumpet a theory which says that history never changes and that things will get better. That's as mechanistic and false a theory as Marxism. As of now, were muddling through, but I'm not willing to take that fact for granted. Contrary to Simon Jenkins, nothing is written, not even for us. We will have to make our own future.

"So if stimulus is partly a game of psychology"

Barbara Kiviat finds someone on my side:

"Obama talks stimulus. He hopes you are listening

Posted by Barbara Kiviat | Comments (6) | Permalink | Trackbacks (0) | Email This

The spate of retailers reporting devastating December sales this morning provided a nice backdrop for President-elect Obama's speech in Virginia about why we need to spend another $775 billion to fix the economy. About 40% of that sum comes in the form of tax cuts, but the bulk of the fiscal stimulus would go to pay for new programs and projects—everything from the greening of federal buildings to the computerization of medical records.

The idea, just to be really basic about it, is that American consumers and companies aren't spending enough, so the government has to. There was a great article in the New York Times yesterday about how pretty much all most economists now agree that it's go-time on this count. Even Marty Feldstein, the champion of conservative economic thought who was a top adviser to President Reagan, has noted that lower interest rates aren't getting the job done because credit markets are screwy and that tax cuts only get you so far, so the "heavy lifting" will have to be done by increased government spending. (Quick historical recap: this hasn't been the consensus in the field of economics since the 1960s.)

But most economists also agree that fiscal stimulus shouldn't be an open-ended thing. This morning I was chatting with Andrew Dilnot, an economist at Oxford University who used to run the U.K's Institute for Fiscal Studies—what he described as a cross between the Congressional Budget Office, the National Bureau of Economic Research and the Brookings Institution. He argued that fiscal stimulus should be geared toward priming the pump—that is, getting private players to start spending again. "The strongest argument for doing these sorts of things is that it's a way of the government demonstrating that they're not going to allow the economy to slide into a depression, that they'll spend the money necessary ( THAT'S MY POSITION. IT'S THE EQUIVALENT OF THE GOVERNMENT GUARANTEES NEEDED TO STOP A CALLING RUN, ONLY THIS IS A PROACTIVITY RUN. HERE, THE GOVERNMENT NEEDS TO BE A SPENDER OF LAST RESORT, AND, ONCE AGAIN, ONLY THE GOVERNMENT HAS THE RESOURCES TO BE BELIEVED AS A SOLR. IT SHOULD ALSO BE CLEAR THAT I BELIEVE THAT HAVING THESE GUARANTEES WILL STOP CALLING AND PROACTIVITY RUNS IN THE FUTURE. THE POINT OF THE GOVERNMENT GUARANTEES SHOULD BE TO KEEP PEOPLE FROM PANICKING, THEREBY KEEPING THE NEED FOR GOVERNMENT ASSISTANCE TO A MINIMUM. )," he said. "If people believe it's going to be okay, then people who are putting off buying a new car or house will instead say, I shan't lose my job, I'll go ahead and do that( THAT'S THE WHOLE POINT. I AGREE. A HUMAN AGENCY EXPLANATION. )."

So if stimulus is partly( COMPLETELY. OTHERWISE, IT'S SIMPLY GOVERNMENT SPENDING AS OPPOSED TO PRIVATE SPENDING. ) a game of psychology, then it would make sense to ease off the extra spending once the economy picks back up( YES ). Get consumers and businesses confident enough to spend again, and then let them take over( YES ). In an interview on Wednesday, Obama nodded at that logic. "I'm not out to increase the size of the government long-term," he said. "My preference would be that the private sector was doing this all on their own( MY POSITION AS WELL. )."

I'm guessing that sounds pretty nice to most folks, especially considering the amount of money we've already spent on fixing the economy. But is it true? Jay Newton-Small has a piece up on Time.com that considers how Obama's stimulus package gives him a running start on a bunch of items on his long-term agenda. If we head down this road and GDP rebounds, do we suddenly cut funding? I know a lot more about economics than I do politics, but I'm guessing most legislation doesn't come with an easy on-off switch( THAT IS A CONCERN ).

Though that's not to say I'm against spending money to increase the energy efficiency of two million homes or to build broadband access to all corners of America so that small businesses, no matter where they're located, can be globally competitive. These are good ideas as far as I'm concerned.( GOOD IDEAS. I AGREE. )

All I'm saying is when we start buying computers for schools and paying people to put up windmills let's be clear about whether we're doing these things to save the economy—or if we'd be trying to do them in the long-term anyway.( FOR THE INFRASTRUCTURE PART OF THE STIMULUS, THIS IS ESSENTIAL. )

Here's one of my favorite parts of Obama's speech:

Instead of politicians doling out money behind a veil of secrecy, decisions about where we invest will be made transparently, and informed by independent experts wherever possible. Every American will be able to hold Washington accountable for these decisions by going online to see how and where their tax dollars are being spent. ( WONDERFUL )

I can't wait.

Barbara!"

My view of the importance and use of a stimulus is exactly the same, which is why I don't believe that we need to do as Paul Krugman says:

"More stimulus notes

Mind the gap

1. The new CBO budget and economic outlook is out. Above is its forecast( BS ) for the GDP gap — the hole stimulus has to fill( WHY DOES IT NEED TO FILL THE HOLE BY ITSELF? ). I’d guess( THAT'S WHAT IT IS ) that the CBO estimate, which has unemployment averaging 8.3 percent in 2009 and 9 percent in 2010, is actually too optimistic (see 3, below), but even so it puts the Obama plan in perspective: a 3% of GDP plan, with a significant share going to ineffective tax cuts( NOT CLEAR AT ALL ), to fill an 8% or more gap.

2. How ineffective? Howard Gleckman of the Tax Policy Center says Lots of Buck, not Much Bang.:

Here's his point:

"Refundable tax credits for hiring new workers promise to be an administrative nightmare and won't create many new jobs. It is tough to see how a company that is seeing its sales slaughtered in today’s recession is going to hire just because it gets a few thousand dollars per new worker from the government. Profitable firms would merely take the credit for bringing on workers they were already planning on hiring. ( IT'S AMAZING HOW PEOPLE CAN INTUITIVELY DIVINE WHETHER OR NOT AN ECONOMIC INCENTIVE WILL WORK. I HAVE NO IDEA WHAT HE'S BASING THIS VIEW ON. IT SEEMS LIKE A POSITIVE MOVE TO ME. )

I can’t begin to imagine how the variation on this idea--credits for not laying someone off--would work( HERE I AGREE ). My head throbs at the concept of the IRS trying to administer a rebate based on intentions. Worse, these breaks would never work unless they are refundable and, to be honest, giving such credits to failing business makes my skin crawl. In reality, it would become yet one more bailout—only this time taxpayers wouldn't even get stock for their trouble."

Back to Krugman:

3. The official BLS numbers won’t be out until Friday, but the ADP jobs estimate, based on private payroll data, is spectacularly grim. "( AND ACCORDING TO THE BIG PICTURE, NOT VERY USEFUL. )

Krugman's view is Mechanistic. The economy is like an engine. It needs a lot of oil. I don't credit this view at all. If there's one view that always wastes money, it's a mechanistic view of human behavior.

I would prefer an incentive for investment, but adding workers isn't a bad alternative. Let me explain something: We're fighting the fear and aversion to risk. One way to attack that is to target incentives to minimally effect this. The alternative is much more than spectacularly grim. There's no proof that any of these measures will be effective, least of all picking an enormous figure based on a graph of useful but inexact numbers. The idea that overspending poses no risk is beyond belief. It is itself a panicked reaction to our crisis. We've had a number of those recently, and, as of now, the record is mixed at best.

"I am convinced however – perhaps a little monomaniacally – that excess liquidity is sufficient and doubt the ability of regulators to prevent bubbles

From Michael Pettis:

"The fun part – assigning blame
January 7th, 2009 by Michael | Filed under Balance sheets, Global liquidity, Policy.
The piece I wrote for YaleGlobalOnline, which I mentioned in my last entry, was published today, and is called “US and China Must Tame Imbalances Together.” In the article I try to argue that the roots of the current financial imbalance – or, more accurately, of the latest and strongest stage of the current financial imbalance ( THE SAVER COUNTRY/SPENDER COUNTRY SYMBIOSIS ) – are buried in the trade and capital relationship between, primarily, China and the US. It is very important, I argue here and elsewhere, that the US and Europe do everything possible to help what could otherwise be a very difficult adjustment for China( IT WILL BE VERY HARD FOR THEM TO SAY GOODBYE TO THIS SYMBIOSIS. ). The editor’s summary of the piece is:

With surging liquidity and massive trade imbalances, no one should have been surprised by the global economic crisis, because as finance professor of Peking University Michael Pettis explains, this has been the historical pattern. Pettis details the history of the crisis, starting in 1980s, when US policy encouraged( WITH GUARANTEES, YES. NOT THE INTEREST RATES THEMSELVES. ) securitization of mortgages, converting illiquid assets into highly liquid investments; US households shifted money into homes( THIS HAS TO DO WITH MANY FACTORS, INCLUDING RETIREMENT PLANS AND RENT TO OWNERSHIP PRICES. ) rather than savings accounts( WHICH DON'T GO UP MUCH, ESPECIALLY IF YOU HAVE TO PAY RENT. ), and housing prices climbed; China, enjoying a trade surplus, collected US dollars and invested in US assets. A self-reinforcing cycle led( THEY CHOSE. ) US consumers to buy more, Chinese factories to produce more, banks in both countries to lend more, and the bubbles burst in late 2008. US adjustment is more rapid than China’s, which could lead to a new set of problems. Pettis warns that replacing US household consumption with US government consumption will only perpetuate the imbalances( WHICH IS WHAT CHINA WANTS ), and he urges the two nations to act responsibly, coordinating fiscal and monetary policies to ease US overconsumption and Chinese overproduction.( THIS CAN'T BE DONE UNTIL THE CALLING RUN ENDS. )

The argument I am making here is also part of a spirited discussion among a group of China scholars who communicate regularly on China-related themes. At the heart of the discussion is an argument over the monetary and policy mistakes made by the major players in permitting or even encouraging the credit bubble of the past decade. Although at its worst these kinds of discussions can quickly degenerate into a fruitless who-to-blame invective (”It is all the fault of Chinese polices” versus “It is all the fault of the US failures”), at its best – and the discussion has generally been quite good – it is a real attempt to understand the roots of the current crisis and the still-unclear ways in which it may continue to unfold.

I am not allowed to publish or publicize any of the comments among this group since the moderator wants to encourage completely open discussion, but I can say that one of the participants wondered about the sequence of events and questioned my claim that crises are always caused as a result of periods of excess liquidity ( A TAUTOLOGY. IT'S THE WORD "EXCESS" THAT MAKES IT ONE, SINCE THE EXCESS IS DETERMINED AFTER THE FACT. IT'S A USELESS EXPLANATION. ), and that it is difficult for regulators to prevent excessive( THIS HAS TWO MEANINGS, ONE OF WHICH IS USELESS. "EXCESSIVE" CAN MEAN "AGAINST INVESTING RULES", WHICH IS USEFUL, OR IT CAN SIMPLY MEAN"DETERMINED TO HAVE BEEN SO AFTER THE FACT", WHICH IS OBVIOUS, AND USELESS. ) risk-taking when the financial system is forced to accommodate excess liquidity. I think that this is an interesting enough discussion, and very relevant to China, to repeat the argument and my response.

My friend argues that although he agrees excess liquidity is a necessary condition( I'M FINE WITH THIS ) for credit bubbles, it is not at all clear to him that it is a sufficient condition. Besides excess liquidity, he argues, we need misguided regulatory policies to create a bubble and a subsequent financial collapse. In his view, the Fed was primarily responsible for the crisis because of its failure to regulate the financial system with sufficient rigor, and given the expansion of liquidity, it was only a question of time before that failure would lead to crisis.( A MECHANISTIC EXPLANATION AND USELESS. A HUMAN AGENCY EXPLANATION FOCUSES ON INTENTIONALITY AND PRESUPPOSITIONS. IT IS THE ONLY EXPLANATION OF THIS CRISIS. THE SPIGOT THEORY IS USELESS. )

In my response I argued that it is hard to say if excess liquidity growth is both necessary and sufficient condition for crisis since we would need an objective way to measure excess liquidity growth( EXCEPT AFTER THE FACT ), and that is extremely difficult, at best. The late Frank Fernandez, while chief economist of the Securities Industry Association, spent years trying to do so, but always complained that the financial system was too good at developing new and unexpected ways to expand money.( HE WAS CORRECT. )

I am convinced however – perhaps a little monomaniacally – that excess liquidity is sufficient and I doubt the ability of regulators to prevent bubbles. Part of my skepticism about whether or not a robust regulatory framework can truly prevent credit bubbles is theoretical, and part of it is empirical, with the latter resting on two personal experiences. First, in my reading on financial history and current events there has clearly been tremendous improvement over the past 300 years and more in our understanding of financial risks, the functioning of the financial system, the sophistication of our regulatory institutions, and monetary policy, but absolutely no concomitant reduction in the incidence of credit bubbles. ( ARE HUMAN BEINGS STILL INVOLVED SIR? )

Quite the contrary, and if good regulation prevented crises, why wouldn’t we have seen evidence of gradual improvement in the number and viciousness of crises? Second, as a former smart-ass banker/trader I am too respectful of the enormous ability of the market to game any system that can be put into place( I AGREE ). Regulators simply cannot outplay the market, and when too much liquidity leads( IT DOESN'T DO ANY SUCH THING. THERE ARE INCENTIVES AND DISINCENTIVES TO EVERY HUMAN ACTION, OTHERWISE IT'S NOT AN ACTION. THE VIEW OF HUMAN AGANCY HERE PROPOUNDED IS PURELY MECHANISTIC AND FALSE. ) to an increase in risk appetite, the financial system will find a way to take on more risk that might be healthy. As I argue in my piece, “When any part of the financial system is constrained from taking on risk, the market simply evades these constraints in one of three ways: It innovates around them, it generates or develops new and unregulated parts of the financial system, or it conceals regulatory violations.” ( I AGREE COMPLETELY HERE, WHICH IS WHY I DON'T BLAME THE REGULATIONS OR MATH MODElS OR INVESTMENTS VEHICLES. OTHER WAYS TO LOWER CAPITAL REQUIREMENTS WOULD HAVE BEEN FOUND. )

That leaves me a hard-core Minskyite on financial instability, and it is Minsky who creates the theoretical basis for my skepticism. According to Minsky it is not possible even in theory to eliminate financial instability because the very mechanisms used to control one form of instability will cause changes in the financial system (all those smart-ass bankers/traders) that will create new forms of instability( TRUE ). The whole purpose of a financial system is to intermediate risk, and when risk appetites change( I AGREE, BUT I DISAGREE ABOUT THE CAUSES OF THIS CHANGE. ), the financial system will find a way to accommodate that change, whether or not regulators are comfortable with the change.( TRUE )


That doesn’t mean regulations( I DIFFERENTIATE BETWEEN REGULATION AND SUPERVISION. I BELIEVE THAT WE NEED SUPERVISION, WHICH DOESN'T FOCUS ON RULES BUT METHODS AND GOALS. )) are a waste of time. On the contrary, they are extremely important in the proper functioning of the financial system, but we need to be clear where they matter and where they don’t. As I see it, the purpose of the regulatory framework is:


1) To create a financial system that in “normal” times optimizes the ability of the system to allocate capital cheaply and efficiently. This is where issues of transparency, corporate governance, agency problems and information asymmetry matter.( TRUE )

2) To eliminate balance sheet feedback mechanisms that are automatically pro-cyclical and, to the extent possible, create fiscal and balance sheet stabilizers. These don’t eliminate bubbles and crises, but they do reduce the impact and weaken the transmission mechanism into the real economy. ( TRUE )

To bring this back to China, it is for these reasons that I am more skeptical than most about the recent financial reforms in China. As I see it, the financial system here is replete with balance sheet pro-cyclicality, which the government has not directly addressed (in fact many of their interventions increase the risk) and so China runs the risk of a big, “unexpected” jump in volatility when things turn bad.

The strongest element of counter-cyclicality in China is probably government ownership and control of the banks, but even this is counter-cyclical only up to a point, beyond which it becomes massively pro-cyclical –for example if problems in the banking system ever threaten government credit, which is why I have always advised anyone who will listen that the government should be very sparing in its willingness implicitly or explicitly to guarantee credit risk( I DISAGREE. IT NEEDS TO BE A LOLR TO STOP A CALLING RUN. WHAT ARE NEEDED ARE BAGEHOT'S PRINCIPLES, WHICH WILL KEEP A CALLING RUN FROM OCCURRING. ). Government control of the banks can prevent banks from behaving in ways that exacerbate a downturn, and usually this is a good thing, but in a very severe downturn – like that which Japan experienced after 1990 – the attempt to control banking activity can actually backfire if it leads to a surge in government debt that threatens government credibility( THIS IS WRONG. THE AMOUNT IS A PROBLEM, BUT THAT'S DIFFERENT THAN THE NEED FOR THE GOVERNMENT TO BE A LOLR. ). This loss of government credibility happened in Japan (yet) but it has happened in a number of other cases.

This is basically why I think the liquidity creation generated by the Chinese recycling of the US trade deficit would have led to crisis anyway, even if there had been stronger regulation within the US financial markets( I AGREE ). And, by the way, although I share in the general horror about the huge breaches in our regulatory framework, I also remember that during the enormous petrodollar recycling in the 1970s, the US regulatory framework was much more robust, regulated, rigid and constrained then it is now, but that didn’t prevent excess risk-taking. The only impact of regulatory constraints was that extremely foolish behavior – massive loans to countries that had no chance in hell ever to repay – still occurred among American banks (to such an extent that by the time I joined the market in 1987 only one – JP Morgan – of the top ten US banks was not insolvent) but they occurred outside the regulatory constraint. For all the regulatory prudence the risky behavior simply migrated ( THIS IS WHAT WILL HAPPEN. TO SOME EXTENT, IT DID THIS TIME. )to London, where international banks were not as strictly regulated by their home countries.

The real fault of the Fed in the current crisis, in my opinion, was not to foresee that this unsustainable system would eventually come to a breathtaking close, and to prepare the stabilizers that would have prevented the decimation of the US financial system and its brutal transmission into the real economy. In fact every time they intervened to prevent the system from clearing, they increased the accumulation of balance sheet mismatches( TRUE. BUT, COME ON, THE BUSH ADMINISTRATION IS THE MAIN CULPRIT HERE. ). The regulators did have a role( COLLUSION ), but it was not to prevent the crisis but rather to mitigate( WORSEN ) its impact. In my opinion the Fed could not have prevented the crisis except by engineering a recession in the US to counteract strong mercantilist policies in Asia, and that is perhaps a lot to ask( IMPOSSIBLE. I HAD A BAD FEELING THAT THIS IS WHERE HE WAS GOING. RECESSION ON A THEORY. SURE, LET'S STOP PEOPLE DOING WELL ON A THEORY. ).

One last thing about the joy of assigning blame, I have read and re-read several times Charles McKay’s Extraordinary Popular delusions and the Madness of Crowds and thought I should post the following selection from his chapter on the South Sea Bubble – after the bubble collapsed brining ruin in its wake:

The state of matters all over the country was so alarming, that George I shortened his intended stay in Hanover, and returned in all haste to England. He arrived on the 11th of November, and parliament was summoned to meet on the 8th of December. In the mean time, public meetings were held in every considerable town of the empire, at which petitions were adopted, praying the vengeance of the Legislature upon the South-Sea directors, who, by their fraudulent( FRAUD. DO YOU SEE THAT? FRAUD. ) practices, had brought the nation to the brink of ruin. Nobody seemed to imagine that the nation itself was as culpable as the South-Sea company. Nobody blamed the credulity and avarice of the people,—the degrading lust of gain, which had swallowed up every nobler quality in the national character, or the infatuation which had made the multitude run their heads with such frantic eagerness into the net held out for them by scheming projectors. These things were never mentioned. The people were a simple, honest, hard-working people, ruined by a gang of robbers, who were to be hanged, drawn, and quartered without mercy.( WELL, THIS IS TRUE. GULLIBILITY ISN'T A CRIME. FRAUD IS. )

This was the almost unanimous feeling of the country. The two Houses of Parliament were not more reasonable. Before the guilt of the South-Sea directors was known, punishment was the only cry. The king, in his speech from the throne, expressed his hope that they would remember that all their prudence, temper, and resolution were necessary to find out and apply the proper remedy for their misfortunes. In the debate on the answer to the address, several speakers indulged in the most violent invectives against the directors of the South-Sea project. The Lord Molesworth was particularly vehement. “It had been said by some, that there was no law to punish the directors of the South-Sea company, who were justly looked upon as the authors of the present misfortunes of the state. In his opinion they ought upon this occasion to follow the example of the ancient Romans, who, having no law against parricide, because their legislators supposed no son could be so unnaturally wicked as to embrue his hands in his father’s blood, made a law to punish this heinous crime as soon as it was committed. They adjudged the guilty wretch to be sown in a sack, and thrown alive into the Tiber. He looked upon the contrivers and executors of the villanous South-Sea scheme as the parricides of their country, and should be satisfied to see them tied in like manner in sacks, and thrown into the Thames.” Other members spoke with as much want of temper and discretion.

Mr. Walpole was more moderate. He recommended that their first care should be to restore public credit. “If the city of London were on fire, all wise men would aid in extinguishing the flames, and preventing the spread of the conflagration before they inquired after the incendiaries. Public credit had received a dangerous wound, and lay bleeding, and they ought to apply a speedy remedy to it. It was time enough to punish the assassin afterwards.” On the 9th of December an address, in answer to his majesty’s speech, was agreed upon, after an amendment, which was carried without a division, that words should be added expressive of the determination of the house not only to seek a remedy for the national distresses, but to punish the authors of them.

Robert Walpole, for those who don’t remember, was the brilliant (if not always scrupulous) statesman – effectively Britain’s first Prime Minister, although the title hadn’t yet been invented – who had been more or less pushed out of favor for speaking strongly and often against the South Sea scheme and warning of its consequences. After the collapse, he was called back to London to clean up the mess – predictable, right? Perhaps because he had been so widely reviled for speaking against the South Sea scheme, he was not fully sympathetic to the claims that the whole thing had been a scam foisted on innocent people by evildoers. He was perfectly happy to avoid the whole orgy of blame and deal with the actual consequences, but needless to say blaming the schemers was always likely to be a lot more satisfying than acknowledging that an awful lot of people participated a little too willingly in the whole thing. Walpole was famously a realist – when there were sufficient incentives for foolishness and fraud, he didn’t doubt that even the nicest people would act stupidly or dishonestly."

I'm puzzled by this. If this view is correct, why is fraud a crime? I believe in blame. One thing is for sure, and that is the fact that not punishing crime is an incentive for more of it.As for the last sentence, it is patently false. Walpole was less a realist than a misanthropist. Thankfully, throughout history, we've have many great people who have turned down great incentives and done the right thing. A Human Agency Explanation assigns blame for committing crimes, and endeavors to investigate and prosecute them. Excusing crime by blaming the victims or saying that we are all possible criminals is useless at preventing anything. Rather, it's a trumpet call for crime. No wonder we're in this mess.

"We call this "circling the wagons" because what this argument does is shift the blame."

From Forbes:

"Treasury's Paulson Gets It Wrong
Brian S. Wesbury and Robert Stein 01.06.09, 12:01 AM ET

In a recent interview with the Financial Times, U.S. Treasury Secretary Hank Paulson blamed the credit crisis on global imbalances. Specifically, he repeated a storyline popularized by Alan Greenspan and Ben Bernanke: that a global savings glut (otherwise known as an imbalance) pushed interest rates down around the world and drove( NO ONE HAD TO DO THIS. IT'S A MECHANISTIC EXPLANATION OF HUMAN BEHAVIOR. ) investors toward riskier and more leveraged investment activities( I DON'T CREDIT THIS THEORY AT ALL ).

We call this "circling the wagons" because what this argument does is shift the blame( I AGREE, ONLY I THINK THAT IT SHIFTS THE BLAME AWAY FROM INDIVIDUAL HUMAN DECISIONS. ). It shifts the blame off of the Fed, which pushed interest rates down too far in 2002-2004( I DON'T CREDIT THIS EXPLANATION EITHER, FOR THE SAME REASONS GIVEN ABOVE ABOUT THE GIANT SLOSHING POOL OF MONEY. ). It also lets the Fed off the hook for using the phrase "considerable period" back in 2003 when the federal funds rate was 1%--that was how long it said it wanted to hold interest rates low. That language was designed to lower long-term interest rates by basically double-daring( YOU HAVE TO ACCEPT A DARE? ) hedge funds and investment banks to use massive leverage--borrow short at low rates and buy long at higher rates.

It lets rating agencies, which are sanctioned by the federal government, slide despite their huge mistakes( CRIMES. BUT I AGREE. ). It whitewashes Fannie Mae, Freddie Mac and the politicians who supported their ability to hold mortgage rates down artificially( STILL NO EXCUSE FOR BAD LOANS. ANOTHER MECHANISTIC EXPLANATION. ). It also ignores rules and regulations, such as the Community Reinvestment Act (which forced banks( COME ON ) to make low income loans) and mark-to-market accounting (which artificially( SENSIBLY ) pushed up capital ratios at financial institutions in the early 2000s as the Fed cut interest rates and risk spreads narrowed as leverage increased).

Most important, it fans fears( THEY'RE ALREADY WELL-FANNED ) of global financial markets, free trade and free markets in general. If this argument influences the policy debate, it will lead toward protectionism or devaluation, both of which would harm the U.S. economy.

The Greenspan/Bernanke/Paulson theory suggests that China (in particular), as well as other countries holding massive reserves, created a glut of savings and low interest rates. The way China accumulated these dollars was by running a trade surplus. Never mind that the U.S. was running a deficit exactly equal to the rest of the world's surplus and the last time we looked, exactly equal meant "balanced."( THE SPENDER COUNTRY/SAVER COUNTRY SYMBIOSIS ) Never mind that, because what the Treasury Secretary is supporting is an argument that the trade deficit is a problem. This creates another support for those who want to see a U.S. devaluation or the introduction of more barriers to trade.

Despite the high level of support for this "global imbalances" argument, we remain skeptical. First, the Fed controls short-term interest rates. And when the Fed signals that it will hold rates low for a considerable period (as in 2003), this encourages( AT BEST. IT DOESN"T DETERMINE. ) what Mr. Paulson called the "mis-pricing" of risk.

Second, if China (or other high trade surplus countries) used accumulated dollars to purchase goods and services from the U.S., those dollars would not disappear, they would still be in circulation.

So the idea that somehow there is a glut of money because one country or another is holding a big stash ignores the fact that no matter what that country did with the money it would still exist. If it were spent it would represent sales, profits, incomes and savings for some other entity. For every debit, there must be a credit. For every trade surplus, there must be a deficit. For every so-called imbalance on one side of the ocean, there exists an equal but opposite imbalance on the other side of the ocean. There are no leaks; the world, when it comes to dollars, is a closed system.

While we understand the desire to circle the wagons and shift blame, the idea that a global savings glut destroyed the economy is seriously wanting( I AGREE. NOT USEFUL. ). We hope this is not the only explanation for our current financial crisis that policy-makers employ. The underlying cause of a crisis is important to understand. If policy-makers are mistaken, then policy responses will be flawed.( THIS IS TRUE, BUT THEY ARE ALSO WRONG IN FOLLOWING MECHANISTIC EXPLANATIONS OF THE CRISIS, WHICH ARE ALL OF LITTLE USE. )

Brian S. Wesbury is chief economist, and Robert Stein senior economist, at First Trust Advisors in Lisle, Ill. They write a weekly column for Forbes.com."

"Much of today’s financial regulation assumes that risk can be accurately measured"

A view about regulation on Vox from Jon Danielsson:

"The myth of the riskometer

Much of today’s financial regulation assumes( MECHANISTIC EXPLANATION ) that risk can be accurately measured – that financial engineers, like civil engineers, can design safe products with sophisticated maths informed by historical estimates. But, as the crisis has shown, the laws of finance react to financial engineers’ creations, rendering risk calculations invalid. Regulators should rely on simpler methods.(HUMAN AGENCY EXPLANATIONS )

There is a widely held belief that financial risk is easily measured – that we can stick some sort of riskometer( CAN'T BE DONE ) deep into the bowels of the financial system and get an accurate measurement of the risk of complex financial instruments. Such misguided belief in this riskometer played a key role in getting the financial system into the mess it is in.

Unfortunately, the lessons have not been learned. Risk sensitivity is expected to play a key role both in the future regulatory system and new areas such as executive compensation.

Origins of the myth

Where does this belief come from? Perhaps the riskometer is incredibly clever – after all, it is designed by some of the smartest people around, using incredibly sophisticated mathematics.

Perhaps this belief also comes from what we know about physics. By understanding the laws of nature, engineers are able to create the most amazing things. If we can leverage the laws of nature into an Airbus 380, we surely must be able to leverage the laws of finance into a CDO.

This is false. The laws of finance are not the same as the laws of nature. The engineer, by understanding physics, can create structures that are safe regardless of what natures throws at them because the engineer reacts to nature but nature does not generally react to the engineer.( NOT IN THE SAME WAY )

The problem is endogenous risk

In physics, complexity is a virtue( NO. SIMPLICITY IS A VIRTUE. ). It enables us to create supercomputers and iPods. In finance, complexity used to be a virtue. The more complex the instruments are, the more opaque they are, and the more money you make. So long as the underlying risk assumptions are correct( USEFUL ), the complex product is sound. In finance, complexity has become a vice( JUSTIFICATION FOR UNSOUND INVESTMENTS ).

We can create the most sophisticated financial models, but immediately when they are put to use, the financial system changes. Outcomes in the financial system aggregate intelligent human behaviour( TRUE. BUT THAT'S TRUE OF ALL OF THE HUMAN SCIENCES. ). Therefore attempting to forecast prices or risk using past observations is generally impossible( THAT'S FALSE. PREDICTING THE FUTURE PERFECTLY ISN'T POSSIBLE. ). This is what Hyun Song Shin and I called endogenous risk (Danielsson and Shin 2003).( IT'S NOT THAT PROFOUND )

Because of endogenous risk, financial risk forecasting is one of the hardest things we do( SO WHAT? ). In Danielsson (2008), I tried what is perhaps the easiest risk modelling exercise there is – forecasting value-at-risk for IBM stock. The resulting number was about +/- 30% accurate, depending on the model and assumptions. And this is the best case scenario. Trying to model the risk in more complicated assets is much more inaccurate. +/- 30% accurate is the best we can do( THE BEST YOU CAN DO ).

Applying the riskometer

The inaccuracy of risk modelling does not prevent us from trying to measure risk, and when we have such a measurement, we can create the most amazing structures – CDOs, SIVs, CDSs, and the entire alphabet soup of instruments limited only by our mathematical ability and imagination. Unfortunately, if the underlying foundation is based on sand, the whole structure becomes unstable. What the quants missed was that the underlying assumptions were false.( ABOUT MODELS AND REALITY, YES. )

We don’t seem to be learning the lesson, as argued by Taleb and Triana (2008), that “risk methods that failed dramatically in the real world continue to be taught to students”, adding “a method heavily grounded( HERE'S THE PROBLEM ) on those same quantitative and theoretical principles, called Value at Risk, continued to be widely used. It was this that was to blame for the crisis( I DON'T AGREE ).”

When complicated models are used to create financial products, the designer looks at historical prices for guidance. If in history prices are generally increasing and risk is apparently low, that will become the prediction for the future( IF YOU'RE A ROBOT ). Thus a bubble is created( THAT'S NOT THE CAUSE OF A BUBBLE. SORRY. ). Increasing prices feed into the models, inflating valuations, inflating prices more. This is how most models work( BUT NOT PEOPLE ), and this is why models are often so wrong. We cannot stick a riskometer( THERE ISN'T ONE ) into a CDO and get an accurate reading.

Risk sensitivity and financial regulations

One of the biggest problems leading up to the crisis was the twin belief that risk could be modelled( IT'S JUST A MODEL ) and that complexity was good( NOT GOOD ). Certainly the regulators who made risk sensitivity the centrepiece of the Basel 2 Accord believed this.

Under Basel 2, bank capital is risk-sensitive. What that means is that a financial institution is required to measure the riskiness of its assets, and the riskier the assets the more capital it has to hold. At a first glance, this is a sensible idea, after all why should we not want capital to reflect riskiness? But there are at least three main problems:( 1 ) the measurement of risk, ( 2 )procyclicality (see Danielsson et. al 2001), and the( 3 ) determination of capital.

To have risk-sensitive capital we need to measure risk, i.e. apply the riskometer. In the absence of accurate( TRUE ) risk measurements, risk-sensitive bank capital is at best meaningless and at worst dangerous.

Risk-sensitive capital can( MAYBE ) be dangerous because it gives a false sense of security. In the same way it is so hard to measure risk, it is also easy to manipulate risk measurements( THIS IS TRUE ). It is a straightforward exercise to manipulate risk measurements to give vastly different outcomes in an entirely plausible and justifiable manner, without affecting the real underlying risk. A financial institution can easily report low risk levels whilst deliberately or otherwise assuming much higher risk. This of course means that risk calculations used for the calculation of capital are inevitably suspect.( HERE I AGREE )

The financial engineering premium

Related to this is the problem of determining what exactly is capital. The standards for determining capital are not set in stone; they vary between countries and even between institutions. Indeed, a vast industry of capital structure experts exists explicitly to manipulate capital, making capital appear as high as possible while making it in reality as low as possible( TRUE. LEVERAGING. ).

The unreliability of capital calculations becomes especially visible when we compare standard capital calculations under international standards with the American leverage ratio. The leverage ratio limits the capital to assets ratio of banks and is therefore a much more conservative measure of capital than the risk-based capital of Basel 2. Because it is more conservative, it is much harder to manipulate.( IT'S ALSO MORE CONSERVATIVE, AND INHERENTLY LESS RISKY. I DON'T FOLLOW THE HARDER ARGUMENT. )

One thing we have learned in the crisis is that banks that were thought to have adequate capital have been found lacking( AND? ). A number of recent studies have looked at the various calculations of bank capital and found that some of the most highly capitalised banks under Basel 2 are the lowest capitalised under the leverage ratio, an effect we could call the financial engineering premium.( NO. COMPLETELY WRONG. THE BANKS AND INVESTORS WERE LOOKING FOR WAYS TO CUT CAPITAL RESTRICTIONS. THAT'S WHY THEY CHOSE CDSs, CDOs, AND THE MATH MODELS THAT JUSTIFY THEM. THEY COULD HAVE CHOSEN OTHER LESS MATHEMATICAL WAYS OF DOING THIS. )

As Philipp Hildebrand (2008) of the Swiss National Bank recently observed “Looking at risk-based capital measures, the two large Swiss banks were among the best-capitalised large international banks in the world. Looking at simple leverage( THAT'S ALWAYS WHAT YOU NEED TO LOOK AT ), however, these institutions were among the worst-capitalised banks”

The riskometer and bonuses

We are now seeing risk sensitivity applied to new areas such as executive compensation. A recent example is a report from UBS (2008) on their future model for compensation, where it is stated that “variable compensation will be based on clear performance criteria which are linked to risk-adjusted value creation.” The idea seems laudable – of course we want the compensation of UBS executives to be increasingly risk sensitive.

The problem is that whilst such risk sensitivity may be intuitively and theoretically attractive, it is difficult or impossible to achieve in practice. One thing we have learned in the crisis is that executives have been able to assume much more risk than desired by the bank( TRUE ). A key reason why they were able to do so was that they understood the models and the risk in their own positions much better than other parts of the bank( TRUE ). It is hard to see why more risk-sensitive compensation would solve that problem. After all, the individual who has the deepest understanding of positions and the models is in the best place to manipulate the risk models. Increasing the risk sensitivity of executive compensation seems to be the lazy way out.( THERE ARE BETTER WAYS )

This problem might not be too bad because UBS will not pay out all the bonuses in one go, instead, “Even if an executive leaves the company, the balance (i.e. remaining bonuses) will be kept at-risk for a period of three years in order to capture any tail risk events.” Unfortunately, the fact that a tail event is realised does not by itself imply that tail risk was high, and conversely, the absence of such an event does not imply risk was low. If UBS denies bonus payments when losses occur in the future and pays them out when no losses occur, all it has accomplished is rewarding the lucky and inviting lawsuits from the unlucky. The underlying problem is not really solved.( NOT REALLY, NO )

Conclusion

The myth of the riskometer is alive and kicking. In spite of a large body of empirical evidence identifying the difficulties in measuring financial risk, policymakers and financial institutions alike continue to promote risk sensitivity.

The reasons may have to do with the fact that risk sensitivity is intuitively attractive, and the counter arguments complex. The crisis, however, shows us the folly of the riskometer. Let us hope that decision makers will rely on other methods.

References

Danielsson, Jon and Hyun Song Shin, 2003, “Endogenous Risk”, chapter in Modern Risk Management: A History.
Danielsson, Jon, Paul Embrechts, Charles Goodhart, Con Keating, Felix Muennich, Olivier Renault and Hyun Song Shin (2001) “An Academic Response to Basel II”, 2001.
Danielsson, Jon (2008) “Blame the models”, VoxEU.org, 8 May 2008
Hildebrand, Philipp M. (2008) “Is Basel II Enough? The Benefits of a Leverage Ratio”, Financial Markets Group Lecture, London School of Economics .
Taleb, Nassim Nicholas and Pablo Triana (2008) “Bystanders to this financial crime were many” Financial Times December 7.
UBS (2008) “Compensation report: UBS’s new compensation model”

This is a strange argument. There is no riskometer. There are math models that are more or less useful. I don't see any argument that they can't be useful. Blaming the crisis on math models is itself a mechanistic explanation, based upon an incorrect understanding of how and why theories are useful. A theory or model can have very limited scope and be useful.

A warning about how models relate to the world is important, but it is possible to measure( although I don't like the word "measure" ) risk. If it weren't, no one would do anything.