""I don't know anybody involved who thought he could predict these turning points."

Via Marginal Revolution, Drake Bennett on the Boston Globe discusses the current state of Economics:

"THE DEEPENING ECONOMIC downturn has been hard on a lot of people, but it has been hard in a particular way for economists. For most of us, pain and apprehension have been mixed with a sense of grim amazement at the complexity( CONNECTEDNESS ) of what has unfolded: the dense, invisible lattice connecting house prices ( A BUBBLE ) to insurance companies( POOR DECISIONS ) to job losses( MANY PREEMPTIVE ) to car sales( LIKE HOUSES, FINANCED THROUGH CREDIT WHICH IS NOW HARD TO GET ), the inscrutability of the financial instruments( VASTLY OVERSTATES THE COMPLEXITY ) that helped to spread( HIDE ) the poison, the sense that the ratings agencies and regulatory bodies were overmatched( TRY CONFLICT OF INTEREST ) by events, the wild gyrations( AMIDST THE WILD GYRATION'S OF GOVERNMENT POLICIES ) of the stock market in the past few months( NO MENTION OF FRAUD AND GOVERNMENT GUARANTEES ). It's hard enough to understand what's happening, and it seems absurd to think we could have seen it( WE MIGHT HAVE TRIED PREPARING FOR IT ) coming beforehand. The vast majority of us, after all, are not experts ( THANK GOD ).

	Discuss
	COMMENTS (8)

(Getty Images, Globe Staff photo illustration)

But academic economists are. And with very few exceptions, they did not predict the crisis, either( WERE THEY SUPPOSED TO? ). Some warned of a housing bubble, but almost none foresaw the resulting cataclysm. An entire field of experts dedicated to studying the behavior of markets failed to anticipate what may prove to be the biggest economic collapse of our lifetime. And, now that we're in the middle of it, many frankly admit that they're not sure how to prevent things from getting worse( THAT'S SIMPLY THE TRUTH ).

As a result, there's a sense among some economists that, as they try to figure out how to fix the economy, they are also trying to fix their own profession. The discussion has played out in blog posts and opinion pieces, in congressional testimony and at conferences and in working papers. A field that has increasingly been defined, at least in the public eye, by quirky studies explaining the economics of our everyday lives - most famously in the best-selling book "Freakonomics" - has turned decisively, in the last couple months, to more traditional economic turf. And at economics powerhouses like Harvard, MIT, and the University of Chicago, faculty lunch discussions that once might have centered on theoretical questions and the finer points of Bayesian analysis are now given over to dissecting bailout plans. Long-held ideas - about the stability of the business cycle, the resilience of markets, and the power of monetary policy - are being challenged ( GOOD ).

"Everyone that I know in economics, and particularly in the worlds of academic finance and academic macroeconomics, is going back to the drawing board( AGAIN, TRY A NOTEBOOK )," says David Laibson, a Harvard economist. "There are very, very, very few economists who can be proud( THAT'S SILLY )."

A few are suggesting, as well, that there are deeper problems in the discipline. Economists are asking aloud whether the field has grown too specialized, too abstract - and too divorced, in some sense, from the way real-world economies actually function( TRUE, BUT THAT HAS MORE TO DO WITH NOT RECOGNIZING OR CARING ABOUT THE DIFFERENCE BETWEEN ECONOMICS AND POLITICAL ECONOMY ). They argue that many of the models used to explain and predict the dynamics of financial markets or national economies have been scrubbed clean, in the interest of theoretical elegance( THERE'S A POINT TO THIS AT THE KANTIAN LEVEL OF EXPLANATION ), of the inevitable erraticism of human behavior( THAT'S WHY WE NEED HUMAN AGENCY EXPLANATIONS, WHICH ARE EXISTENTIAL ). As a result, the analytical tools of the trade offer little help in a crisis, and have little to say about the sort of collapses that led to this one( IF THEY TURNED TO POLITICAL ECONOMY, THEIR HELP WOULD BE QUITE USEFUL ).

"You can't just say, 'I have a model for tremors that works great, I just can't explain earthquakes,'( YOU JUST DID ) " says Kenneth Rogoff, a Harvard economist who has studied financial crises.

Historically, periods of severe economic distress have shaken up economics, and helped drive its evolution. And in the midst of the current crash, there is an urgent search for approaches and models that might better illuminate how to speed the recovery and forecast future meltdowns, and that might help us better understand the unruly flow of money.( UNRULY, ERRATICISM, GYRATIONS,INSCRUTABIlITY,DENSE,LATTICED,TREMORS, SCRUBBED CLEAN, DISSECTING, CATACLYSM, DEEPER PROBLEMS,BUBBLE, COLLAPSE, PREVENT, EARTHQUAKES, ETC. AND THAT'S JUST SO FAR )

The question of how well economists can model crises takes on an even greater importance because of the central role economic experts will play in Barack Obama's administration - not only at the Federal Reserve, the Council of Economic Advisors, and the Treasury, but in the Economic Recovery Advisory Board, a newly formed body created by the president-elect and headed by former Federal Reserve chairman Paul Volcker. Obama has a reputation as someone who places a great deal of stock in expertise and the power of data ( THAT'S GOOD. JUST MAKE SURE TO DIVERSIFY YOUR PORTFOLIO. SAY, BY ADDING THIS BLOGGER AS COURT JESTER FOR FINANCES ). For better or worse, the evolving understanding of economic breakdowns will have ample opportunity to test itself against the real thing( ISN'T THAT WHAT IT'S SUPPOSED TO DO? EVEN WITH MATH YOU SHOULD TRY ).

Along with everything else they have done, the financial meltdown and attendant economic slump have spurred unprecedented political attention and participation on the part of economists ( THEY'RE BETTER THAN MANY OTHERS ).

"In my lifetime as an economist I've never seen economists so engaged by what's going on," says Richard Thaler of the University of Chicago. "At the University of Chicago people always talk economics at lunch, but for the last three months they've all been talking about the crisis and the bailout, and writing op-eds( HAVE YOU TRIED STUDYING AT ALL? )."

This is something of a change. The topics economists study often have little to do with the average person's economic life - as in most any academic field, practical relevance can have little to do with what questions are deemed most interesting and rewarding. This divergence was exacerbated, many economists say, during the span of almost uninterrupted economic growth that began in the late 1980s, a period when many of the more practical questions in economic policy-making came to be seen as having been settled( NOTHING IS WRITTEN ). For years, leading economic figures like Larry Summers and Alan Greenspan argued that the United States had more or less( THE QUALIFYING SOUNDS A NOTE OF SKEPTICISM FOR ALL WHO CARE TO HEAR. I'M RATHER LIKE ODYSSEUS IN THAT REGARD, AND ONLY THAT ) brought the business cycle to heel ( THEY'RE LIKE TRAINERS IN THIS MODEL ).

Partly as a result, many bright young economists turned to questions that were quirkier, or more purely mathematical. To the wider public, the most visible ramification of this was the boom in papers and books about the economics of everyday life - the best-known practitioner was Steven Levitt of the University of Chicago, but economists like Ray Fisman of Columbia, Edward Miguel of UC Berkeley, and Justin Wolfers of the University of Pennsylvania also worked at least partly in this vein. In often ingenious studies, they used economics as a forensic tool to examine family dynamics, speed-dating, parking scofflaws, basketball games, or the life choices of street criminals.

For those who stayed on more traditional economic turf, however, the trend was toward narrower questions, and more abstract ones. Financial economists set out to figure out why it is that stocks earn more than bonds, or to devise better ways of calculating "beta," the correlation between the price of a single asset and the price of the market it was part of. Others took on the surprisingly difficult question of defining what, exactly, money is.

Wolfers, being an economist, describes these intellectually challenging but less policy-relevant questions as a sort of scholarly "luxury good." "During good times we all consume more luxuries," he says, "but during a bad economy, it feels to macroeconomists that what we should be doing is stuff to help today."

Some economists have suggested that this focus may account for why so many failed to see the warning signs of the financial crisis, and to predict the size and scope of its fallout.

Others see a broader problem in that the sort of behavior we've seen in everyone from home buyers to investment bankers in recent months is hard to fit into economists' analytical tools. The models that macroeconomists - those who study national and regional economies in their entirety - rely on do a poor job of describing the messiness of an actual market in flux( THAT'S WHY WE NEED A HUMAN AGENCY EXPLANATION ). Many, for example, only have one variable for an interest rate, even though in times of economic turmoil the gap between various rates often widens so far that it's difficult to say what "the" interest rate actually is. As a result, economists end up oversimplifying such situations when they model them - or simply avoid studying them at all.( THAT'S POLITICAL ECONOMY )

"We have a very restrictive set of language and tools, and we tend to work on the problems that are easily addressed with those tools ( THIS IS TRUE OF ALL HUMAN ENDEAVOR )," says Jeremy Stein, a financial economist at Harvard. "Sometimes that means we focus on silly questions and ignore greater ones( SO DOES MODERN PHILOSOPHY )."

Today there is a move to hone and rethink the models that describe the huge interlocking wheels of the economy, and to find a way to include the human tendencies that can bring them grinding to a halt. Some economists are looking to the methods and findings of psychology, others are applying themselves to the tricky task of modeling bubbles, a relatively neglected topic. Whatever the approach, the study of financial crises is likely to be a predominant question for the newest generation of economists. ( POLITICAL ECONOMY AND HUMAN AGENCY EXPLANATIONS ARE ALL THAT IS NEEDED,AND ALL THAT WE CAN EXPECT )

"I guarantee that over the next couple of years you are going to see lots of papers on banking crises and financial blowups," says Andrew Lo, a financial economist at MIT's Sloan School of Management.

In addition, others predict, there's likely to be a sharp migration among young economists into these fields. "Banking has been an incredibly important field that has not been hot for some time," says Edward Glaeser, a Harvard University economist. "What's happened is that banking is sexy again ( BECAUSE OF A CRISIS. NOW THAT'S PARADOXICAL )."

Already, the crisis is reshaping long-running debates. It has chastened believers in the self-correcting abilities of the free market - Alan Greenspan said as much before Congress in October - and emboldened those who see the need for more active government intervention( TRUE ).

In a sense, it's a debate that has been seesawing back and forth from crisis to crisis over the past century. Classical economics was devastated by the Great Depression, and in the years afterward gave way to the ideas of the British economist John Maynard Keynes: that individually rational economic decisions could add up to collectively disastrous consequences, that the "stickiness" of prices and wages could lead to long-term unemployment and stagnation, and that the government, as a result, has to step in to kick-start the economy.

The stagflation of the 1970s, while mild compared with the Depression, swung the pendulum back. It was Milton Friedman, a sharp critic of Keynesianism and a fervent advocate of unfettered free markets, who solved the seeming paradox of simultaneous inflation and high unemployment by realizing the deadening power of people's expectation of future inflation, and it was Friedman's proposed solution - sharply restricting the money supply - that eventually, albeit painfully, solved the problem.

Today's crisis has brought Keynes back to the center of the discussion, but some economists also see it driving the field into new territory. Up until very recently, the study of market bubbles was marginalized - there was no widely accepted definition of what a bubble was, and some economists, believers in the complete rationality of markets, argued that bubbles didn't even exist( BRILLIANT ). Today, however, there is a growing sense that understanding bubbles is vital to understanding markets - among those making the case is Federal Reserve chairman Ben Bernanke, who, as head of the Princeton economics department, made a point of hiring young economists interested in the topic( GOOD FOR HIM ).

Over the same time period, the field of so-called behavioral economics has risen to prominence, led by, among others, Thaler, Laibson, and Robert Shiller, a Yale economist who warned of both the housing bubble and, in 2000, the dot-com bubble. By borrowing the insights and methods of psychology, behavioral economics focuses on all the ways in which humans fail to act as the rational, self-interested beings that economic models call for - we aren't good at thinking about the future, we're susceptible to peer pressure, we overestimate our abilities and underrate the odds of bad things happening. It's a set of traits that describes perfectly the behavior of many of the people who, in a cascade of self-defeating decisions, helped create the subprime crisis. ( A GOOD APPROACH )

"People used to think that these behavioral effects were small anomalies that turned up in experiments but washed out in the real world," says Tyler Cowen, an economist at George Mason University not himself affiliated with behavioral economics. "But there's a sense( TRYING LOOKING AND IT WILL BE MORE THAN THAT ) in which they get multiplied in the real world."

For now, behavioral economics remains a critique without a real alternative. That may be starting to change: Lo has developed what he calls the "adaptive markets hypothesis," a model that he argues reflects both the rationality of the investor in good times and the blind panic of the bad( MIGHT HELP ).

Nonetheless, for some economists, the lessons of the crisis are likely to be smaller, though no less humbling. These scholars argue that they're facing not a new challenge but a familiar nemesis.

"What we're experiencing now is a good old-fashioned financial panic," says Jeffrey Kling, an economist at the Brookings Institution. "This is perhaps the biggest scale, but on some level it's not that different( A SLIGHT SIMILARITY )."

Robert Lucas, an economist and Nobel laureate at the University of Chicago and a champion of the rationality of markets, doesn't see much fundamental change coming out of the crisis, either. What it has reminded us of, he argues, is simply the impossibility of seeing these events in advance ( TRUE ).

"I don't know anybody involved who thought he could predict these turning points. Do macroeconomists know as much as we thought we did?" he asks. "Of course not( NO ONE DOES )."

By this logic, the problem isn't how economists see the world so much as it is what we expect of economics ( NOT MUCH ).

Laurence Ball, an economist at Johns Hopkins, makes a similar point. "Nobody ever sees anything coming," he says. "Nobody saw stagflation coming, nobody saw the Great Depression coming, nobody saw Pearl Harbor or 9/11 coming. Really big, bad things tend to be surprises( OTHERWISE THEY WOULDN'T HAVE HAPPENED )."

A little chastening isn't bad, but, please, no hand wringing.

"If the new president had a target of full employment, and if Americans believed that he could reach it the confidence problem could be quickly solved

Robert J. Shiller has a post in the NY Times:

"IN the current crisis, discussions of economic policy have often centered on uninspiring, short-term goals. To restore confidence in our economic future, we need appropriate, firm targets that will clearly put us where we want to be."

I think that we can be excused for dwelling upon the immediate danger in these circumstances.

"For example, President-elect Barack Obama has framed his economic stimulus package in terms of the number of jobs he will create. The goal is to add 2.5 million jobs, he says, by hiring people to improve our highways, fix up our schools and do other infrastructure work around the country. All of that is fine, but it does not represent a commitment to full employment — providing a job for everyone who is willing to work. As a result, confidence remains abysmal.If the new president had a target of full employment, and if Americans believed that he could reach it, the confidence problem could be quickly solved."

I have spent years, ever since reading "The Share Economy", in trying to devise ways to get to full employment. Let me also remind readers that I favor, if I had my druthers, a Guaranteed Income with Health Care being provided within the bounds of that income. In doing this, I am following ideas first propounded by Milton Friedman, and most lately developed by Charles Murray. Within that guarantee, it would obviously be better to find ways for full employment.

"The Great Depression provides an analogy. Presidents Herbert Hoover and Franklin D. Roosevelt had at least a vague idea that economic stimulus would help the situation, but even Roosevelt lacked clear targets for such policies during the New Deal. The economic stimulus applied was inconsistent and inadequate. Confidence waned, and the depression was longer and deeper than it needed to be."

I don't agree with this. I believe that in many ways Roosevelt was more Conservative than Hoover, and found that, in the necessity of dealing with the Depression, he had to alter those beliefs as he went along. I would say that he was Pragmatic, and the fact that we survived is proof of his effectiveness. I've also tried reminding people of the context of the 30s, which is not our context, which was that many people believed that Capitalism was dead, and that Totalitarianism, namely Communism and Socialism, were the only choices. You simply cannot denude any decisions of that time, even Economic ones, of that context. His targets were necessitated by massive threats to our very survival.

"People still remember aspects of that depression history. The Works Progress Administration and the Civilian Conservation Corps tackled infrastructure projects, much as Mr. Obama proposes — but these New Deal programs were not enough to restore full employment. That history reduces the current credibility of Mr. Obama’s target of 2.5 million jobs."

That's because they were experimental, and were being tried out in order to assess their effectiveness.

"On the other hand, there have been some worthwhile targets in monetary policy in recent years. A number of central banks have adopted firm inflation targets, which has helped to contain inflation expectations. Those expectations have tended to coincide roughly with the targets."

I agree.

"At the moment, of course, inflation is no longer the fundamental risk. Our current problems are deflation and recession — possibly even depression — and so we must rethink our targets."

I agree.

"An immediate shift to a full employment target may not be possible, simply because there is no confidence right now that we can hit it. While people seem to believe that central banks can control inflation, there is little consensus that central banks can prevent a depression under circumstances like this."

Here's where I believe that I differ from him and most everybody else. I believe that, prior to Lehman, and even after for a time, people did in fact still believe that the government could avert and deal with this crisis effectively. There has been an ongoing deterioration in that belief throughout this year, with it being almost completely shattered by the performance and effectiveness of recent government policies. A large part of this deterioration, I believe, has to do with a general feeling that the Bush Administration will manage to make things worse. However, because this belief was so widespread and endemic to our actual system of governance and finance, there was no Plan B. Consequently, when the crisis hit, everybody had placed their bets on the government.

From a philosophical perspective, these assumptions limited and limit our possible responses, in the same way that a sentence's meaning is limited by its context and presuppositions. That's why, contrary to what many Kantians believe, you simply cannot toss in any theoretical plan that you can come up with and expect it to work in this context. In fact, it will be as effective as gibberish is in a conversation.

"In a forthcoming book I’ve written with Professor George A. Akerlof of the University of California, Berkeley, we argue that current circumstances call for a couple of intermediate targets. If we can hit them, we may credibly be expected to hit the ultimate target of full employment — and keep inflation at bay. The intermediate targets should be announced forcefully, with an immediate effort to achieve them."

Yes Sir. On the double, Sir.

"First, there should be an intermediate target for conventional fiscal and monetary policy, one ambitious enough to restore full employment in a typical recession. (Fiscal policy is the taxation and expenditure proposed by the president and voted by Congress; monetary policy is the province of the Federal Reserve Board.) "

What's the target?

"This target may be inadequate, however, because we are not in a typical recession. Conventional fiscal and monetary methods may fizzle, as they did in the 1990s in post-bubble Japan. After its stock market and real estate debacle early in the decade, the government of Japan moved its budget into deficit and brought interest rates down to zero. But the economy never entirely recovered, and in due course the government debt rose to 1.71 times the annual gross domestic product, versus a current multiple of 0.74 in the United States."

Does that mean that we might hit the target and yet that not prove target enough? Yes, we don't want to end in Japan's pickle. But we might.

"Similarly, we just do not know whether these measures will work in this country. That is why we also need a second intermediate target, for credit. The ability to borrow should be restored to an appropriate level for a normal economy at full employment."

I think that's what I've been calling a Credit Stimulus. I dimly remember expecting TARP to be that. Well, not really expecting. Praying, more like it.

"This is crucial because the most salient problem in our institutions is the drying up of credit. Without credit, companies that count on outside finance will go bankrupt, requiring an impossibly large fiscal and monetary policy stimulus to achieve full employment."

And your remedy is? Give us the most salient solution, friend.

"Furthermore, as long as the credit crisis continues, the economy’s response to conventional fiscal and monetary policy may be drastically reduced. A person who cannot borrow, for example, is unlikely to buy a car, even if a generous fiscal policy has provided him with the needed down payment. Under the current circumstances, the Keynesian “multiplier,” the economy’s response to fiscal policy, may be unusually low. Our best econometric models just won’t tell us how low."

Chuck them, mate.

"FOR months, the Fed has been working to expand credit, and has invented some good methods for doing so. On Nov. 25, it announced a smart method to jump-start credit, called the Term Asset-Backed Securities Loan Facility, which would issue loans, using securities backed by newly issued consumer and small-business loans as collateral. The Fed has started paying interest on reserves to control the inflationary impact of such a policy."

I think that paying interest on reserves was more like an incentive to save, rather than lend. But that's just me.

"This plan and others like it are promising. But all the government loan programs announced so far represent only a tiny fraction of the $52 trillion of total credit market instruments outstanding. We will need to go much further and extend credit to households and businesses that would otherwise be ignored."

Fine. How do we do that?

"Along with fiscal and monetary policy, credit needs to be targeted on a scale that would get us out of our current economic mess. That’s what Washington should do now."

It's fine to want full employment, but, unless he's arguing that the government just up and guarantee everybody a job, I'm not sure how to get it. If that's what he's saying, why not just say that the government should guarantee everybody a job?

The one point I definitely agree with him on is that this is a Crisis Of Confidence, and policies must address it.

Some Really, Really Scary Things Were Not Facing

I guess that it's all in how you see things. In the 1930s, Totalitarianism was a real possibility. It was not clear to people that Capitalism could survive in any form. For my religion, it wasn't clear any of its adherents would be alive. There were plans for a museum dedicated to its extinction. Most of the vaccines that have extended our lives weren't around. A war of tremendous loss had been recently fought, and a worse war was on the horizon. The decisions made about the economy and how to deal with it were made in that context. There is no way to meaningfully compare the decisions of the 1930s to our time except in very tenuous ways. In abstracting out some principles and policies that might help us, we are losing the most meaningful aspects that influenced those decisions. The look back at the 1930s is more like a search for a narrative similar to ours, which can give us hope that our narrative ends as well for us as did that earlier saga.

This is what I call the Existential Situation or Context or Background to our time. It is similar to the concept that Wittgenstein, Austin, Merleau-Ponty, and their modern followers use to understand Human Agency in all its facets. That's why, when reading the article on Fortune entitled "8 Really, Really Scary Predictions, I wasn't at all frightened. If the economic conditions were to lead to enormous and awful social transformations, then I'd be very worried. But, so far, I don't see that happening. Some do. But, to dip into our 1930s narrative, they are akin to the people in the 1930s who were sure that the only choice was between Communism and Fascism. The role of the individual and human agency to determine the fate of the world was lost on them, and so they only saw the world as competing systems, a competition in which Communism and Fascism were far more ruthless and cunning and therefore destined to survive at the expense of a weak and decadent Capitalism. Jot that down in your notebook for reference.

The list has a few of my favorites:
William Gross
Jim Rogers
Nouriel Roubini
and I'm going to add Robert Shiller and Meredith Whitney, who, although I've criticized them mostly on this blog, I actually like and respect. That's the Paradox Of Human Agency out of which all interesting thought arises.

First, Roubini:

"We are in the middle of a very severe recession that's going to continue through all of 2009 - the worst U.S. recession in the past 50 years. It's the bursting of a huge leveraged-up credit bubble. There's no going back, and there is no bottom to it. It was excessive in everything from subprime to prime, from credit cards to student loans, from corporate bonds to muni bonds. You name it. And it's all reversing right now in a very, very massive way. At this point it's not just a U.S. recession. All of the advanced economies are at the beginning of a hard landing. And emerging markets, beginning with China, are in a severe slowdown. So we're having a global recession and it's becoming worse."

Everything has a bottom. The point is to keep our heads and focus on what works as we try this and that policy. Roubini's view is less Pessimistic than Mechanistic, which is unusual for him.

"Sherif Ali: Truly, for some men nothing is written unless THEY write it."

William Gross:

"While 2008 will probably be best known as the year that global stock markets had their values cut in half, it was really much, much more. It was a year in which every major asset class - stocks, real estate, commodities, even high-yield bonds - suffered significant double-digit percentage losses, resulting in the destruction of over $30 trillion of paper wealth. To blame this on subprime mortgages alone would be to dismiss an era of leveraging that encompassed derivative structures of all types, embodying a belief that economic growth was always and everywhere a certainty and that asset prices never go down. As 2008 nears its conclusion, we as an investor nation have been forced to face a new reality. Wall Street and Main Street are fearful that a recession may be replaced by a near depression.

The outcome essentially depends on the ability of the Obama administration to rejuvenate capitalism's "animal spirits" by substituting the benevolent fist of government for the now invisible hand of Adam Smith. Federal spending and guarantees in the trillions of dollars will be required to fill the gap created by the deleveraging of private balance sheets. In turn, lenders and investors alike must begin to assume risk as opposed to stuffing money in modern-day investment mattresses. The process will take time. Twelve months of the Obama Nation will not be sufficient to heal the damage of a half-century's excessive leverage. The downsizing of private risk positions - replaced by government credit - will also result in reduced profit margins and a slower rate of earnings growth after the bottom is reached. "

I agree with Gross. The revival of the "animal spirits" is the key to solving our malady. We must have policies that target and fight the enormous fear and aversion to risk and the accompanying flight to safety. We should be walking, not running.

"Sherif Ali: Have you no fear, English?
T.E. Lawrence: My fear is my concern. "

Now Shiller:

"We don't currently have anywhere near the level of unemployment that we had in the 1930s, but otherwise there are many similarities between today's environment and the Great Depression, with things happening today that we haven't seen since then. First of all, there's the magnitude of the stock market's move up and down. The real (inflation-corrected) value of the S&P 500 nearly tripled from 1995 to 2000, and by November 2008 was down nearly 60% from its 2000 peak. The only other comparable event was the one in the 1920s where real stock prices more than tripled from 1924 to 1929 and then fell 80% from 1929 to 1932. Second, we've had the biggest housing bust since the Depression. Third, we've seen 0% interest rates. We've actually seen briefly negative short-term interest rates. That hasn't happened since 1941. There was a period from 1938 to 1941 when we were bouncing around at zero and sometimes negative, but that hasn't happened since.

And the list goes on: Our numbers don't go back as far as the Depression, but consumer confidence is plausibly at the lowest level since then. Volatility of the stock market in terms of percentage changes day-to-day is the highest since the Depression. In October 2008 we saw the biggest drop in consumer prices in one month since April 1938. Another thing is that it's a worldwide event, as it was in the Depression.

I'm optimistic that we'll do better this time, but I'm worried that we're vulnerable. One of the lessons from the Depression is that things can smolder for a long time. What I'm worried about right now is that our confidence has been hurt, and that's difficult to restore. No matter what we do, we're trying to deal with a psychological phenomenon. So the Fed can cut interest rates and purchase asset-backed securities, but that only works in really restoring full prosperity if people believe that we're back again. That's a little hard to manage."

I agree completely, of course, that we're dealing primarily with a psychological or human agency problem. Our focus and policies should focus on that.

"[Lawrence has just extinguished a match between his thumb and forefinger. William Potter surreptitiously attempts the same]
William Potter: Ooh! It damn well 'urts!
T.E. Lawrence: Certainly it hurts.
Officer: What's the trick then?
T.E. Lawrence: The trick, William Potter, is not minding that it hurts."

Now Jim Rogers:

"We are in a period of forced liquidation, which has happened only eight or nine times in the past 150 years. The fact that it's historic doesn't make it any more fun, of course. But it is a pretty interesting time when there is forced selling of everything with no regard for facts or fundamentals at all. Historically, the way you make money in times like these is that you find things where the fundamentals are unimpaired. The fundamentals of GM are impaired. The fundamentals of Citigroup are impaired.

Virtually the only asset class I know where the fundamentals are not impaired - in fact, where they are actually improving - is commodities. Farmers cannot get a loan to buy fertilizer right now. Nobody's going to get a loan to open a zinc or a lead mine. Meanwhile, every day the supply of commodities shrinks more and more. Nobody can invest in productive capacity, even if he wants to. You're going to see gigantic shortages developing over the next few years. The inventories of food worldwide are already at the lowest levels they've been in 50 years. This may turn into the Great Depression II. But if and when we come out of this, commodities are going to lead the way, just as they did in the 1970s when everything was a disaster and commodities went through the roof."

I have said over and over that, just as on the trip up, people were disregarding the fundamentals, so they are doing on the way down. We need to be able to see more clearly.

"Prince Feisal: Gasim's time has come, Lawrence. It is written.
T.E. Lawrence: Nothing is written.
Sherif Ali: You will not be at Aqaba, English! Go back, blasphemer... but you will not be at Aqaba!
T.E. Lawrence: I shall be at Aqaba. That, IS written.
[pointing to forehead]
T.E. Lawrence: In here. "

Now Meredith Whitney:

"What the federal government has done so far- with TARP, bailing out Citigroup, etc. - has stemmed the bleeding, but what it hasn't done is fundamentally alter the landscape. Yes, there's been a tremendous amount of capital thrown into the system, but my concern is that it's just going to plug the holes. It's not going to create new liquidity, which is what the system so desperately needs.

When the government announces these plans, investors get excited and hopeful. But details have been slim, and while I appreciate the government saying, "We've been wrong here. Let's try something different," the strategy changes have not solved anything. So far we've had TARP 1.0, TARP 2.0, and TARP 3.0, and I'm certain there will be a 4.0, a 5.0, and a 6.0. There has to be, because the companies cannot raise the capital they need, which means that the default provider of capital has to be the federal government.

What happens in 2009? Frankly, it's hard for me to predict what's going to happen next week, never mind next year. What I will say is that I expect all these banks to be back in the market looking for more capital. We'll also have a wholesale restructuring of our banking system, probably toward the end of 2009. There will be banks getting smaller, banks going away, and banks consolidating. At the same time, though, I think you'll see more new banks created. We've already seen more applications. And it's a great idea: You start with a clean balance sheet and make loans today with today's information. Plus, right now you've got a yield curve that's good for lending."

A very pragamtic and sensible approach. And I agree with her about the banks.

Let's throw in a few more points. Wilbur Ross:

"We are clearly in a serious recession, and more aggressive action is needed to turn things around. The federal government initially underestimated the scale of the mortgage and housing crises and later panicked into an ever-changing series of ad hoc measures that at best dealt with some of the effects of the original crises. But homeowners have now lost $5 trillion, and 12 million families have mortgages in excess of the value of their homes. Therefore the economy will not stabilize until mortgages are adjusted down to the value of homes, with affordable payment schedules, and until new mortgages become available across the home-price spectrum. Till then, the poverty effect of falling house prices and unemployment moving up toward 7% will hold consumer spending back from its former 70% contribution to our economy.

I'm optimistic about the choices that President-elect Obama has made for his economic team, and I've got some suggestions for what they should do. Hopefully the new Treasury Secretary, Tim Geithner, will incentivize lenders to restructure mortgages by guaranteeing half of the reduced principal amount and sharing among the government, homeowners, and lenders any subsequent appreciation. Lenders would gain liquidity by selling the Treasury-guaranteed portion of the loan, and government would receive annual insurance premiums to further protect it against loss. That would cost taxpayers nothing now and probably little or nothing in the future.

Addressing unemployment is paramount. Detroit needs government support in order to implement independently verified concessions from all stakeholders - not just labor - which are sufficiently large to permit profitable operations even if auto sales remain as low as 11 million cars per year. A pre-negotiated bankruptcy may be necessary in order to implement the restructuring, but both the industry and the economy are too fragile to withstand the domino effect that a free-fall bankruptcy would have on a car company, its dealers, and its suppliers.

In addition, to avoid reversal of the 242,000 jobs created by state and local governments in the past 12 months, Washington should provide or guarantee funding for sorely needed infrastructure projects that would create immediate construction jobs and meaningful amounts of permanent jobs.

If President Obama promptly and decisively resolves these problems, whether or not he adopts my recommendations, and restores public confidence, he can end the recession by early 2010. If not, the economy will languish for a long time. Given the economic uncertainty, investors who are too worried to buy equities might consider tax-exempt bonds with yields around 6%, equivalent to almost 10% before federal, state, and local taxes."

I like this response. It seems politically very close to my own, and he also focuses on the ad hoc nature of the government's response.

"Prince Feisal: You, I suspect, are chief architect of this compromise. What do you think?
Mr. Dryden: Me, your Highness? On the whole, I wish I'd stayed in Tunbridge Wells. "

John Train:

"I presume that although we are in a severe recession it will not decompose into a full-scale depression, because that is what everyone is afraid of and desperate to avoid. Wall Street likes to say that the market has anticipated five of the last three recessions - the point being that a market crash frightens the authorities into taking necessary action.

Keynes observed that pragmatic businessmen often could not imagine that they were the slaves of defunct economists, but ironically, never is this more true than today of Keynes himself. So we run a huge deficit to postpone the worst. That means inflation, so bonds are unsatisfactory.

Investment opportunity is the difference between the reality and the perception. And since many equities are priced as though a depression might be on the way, many of them are attractively priced."

The difference between perception and reality. Another epistemologist manque. I agree. That's basically the problem. We need to learn to see again.

"Auda abu Tayi: [as Lawrence sets out across the desert with Daoud and Faraj] You will cross Sinai?
T.E. Lawrence: Moses did!
Auda abu Tayi: And you will take the children?
T.E. Lawrence: Moses did! "

Sheila Bair:

"The private-label mortgage-backed securitization markets are a prime example. Trillions of dollars of investor money funded millions of mortgages that borrowers had little chance of repaying. Investors relied heavily on ratings agencies, which in turn relied too heavily on mathematical models instead of analyzing the underlying loans. To be sure, borrowers, brokers, lenders, securitizers, as well as state and federal regulators, all bear responsibility for the widespread deterioration in lending standards. But the problem was compounded by the fact that those ultimately holding the risk - the investors - did not look behind their investments at the quality of the mortgages themselves. If they had, they would have seen high loan-to-value ratios, little income documentation, burdensome fees, and steep payment resets. They would have seen mortgages unaffordable from the beginning, originated based on the assumption that home prices would continue to rise and borrowers would refinance. Of course, we now know that as home prices began to depreciate, borrowers were unable to refinance, leading to massive foreclosures and further price declines. This self-reinforcing downward spiral is at the core of the economic problems we face today.

We will dig out of this. And when we do, I hope for a back-to-basics society - where banks and other lending institutions promote real growth and long-term value for the economy, and where American families have rediscovered the peace of mind of financial security achieved through saving and investing wisely. We need to return to the culture of thrift that my mother and her generation learned the hard way through years of hardship and deprivation. Those are lessons learned that the current crisis is teaching us again."

This is all true. It was actual human decisions that caused the mess. What we need to do is find the presuppositions that they were working under and whether their actions are something worse than lack of foresight and stupidity.

"Club Secretary: I say, Lawrence. You are a clown!
T.E. Lawrence: We can't all be lion tamers. "

Did you find this all that scary? Troubling and needing a mountain of compassion and hard work, but not necessarily scary. Imagine no FDIC at all.

So, that's my take. And, paradoxically, I used the example of British actions in WW I which can be said to have led to many of our current maladies worldwide.

"T.E. Lawrence: The truth is: I'm an ordinary man. You might've told me that, Dryden. "

"The sooner prices are allowed to naturally fall to normal, post-bubble levels, and the sooner that houses become affordable"

I said that there were people who felt that the Fed's plan to help people buy houses was a mistake. Declan McCullagh on CBS News is one of them:

"In reality, more government intervention will do more harm than good. The sooner prices are allowed to naturally fall to normal, post-bubble levels, and the sooner that houses become affordable, the sooner the economy can heal itself and start growing instead of contracting.

By way of analogy, imagine a reprise of the Dutch tulip mania of 1637. Say the price of tulip bulbs has grown handsomely in the last few years, and impressive fortunes were made by early speculators.

Bidding wars erupt, with the winners hoping to resell them the bulbs at a handsome profit months or years later. Cable TV hosts proclaim that a golden age of prosperity has dawned. Prized bulbs change hands for $1 million each, and skeptics are reviled as doomsayers.

Eventually this boom leads to a bust, as new buyers become scarce, and the price of tulip bulbs suffers a dizzying fall down to $10 each. Speculators complain to Congress. Politicians pledge to use tax dollars to purchase bulbs for $1,000 or $10,000, invoking phrases like "stability" and "liquidity crisis," or offering taxpayer-backed loan guarantees to speculators.

This would sound silly for tulips, but it's close to what's happening for houses. All this will do is slow -- and not arrest -- the process of prices falling. Not even the president of the United States can veto the laws of supply and demand.

It's difficult to convince someone to buy a tulip bulb (or house) today if he thinks the price will be a lot lower in a year. Worse, government spending diverts funds away from productive purposes, including investment, education, and infrastructure. "

In general, I agree with this. But, there's one problem with this comment. It assumes that the people buying houses now won't be able to make their payments going forward. But what if they can? What if the problem isn't that current home purchasers are going to get into trouble, and banks aren't lending to them because of that. Rather, many people who can clearly afford the houses they are going to buy are being turned down because of the situation of the banks, which is being locked into a shell-shocked aversion to risk, and using money to clean up their books? How would you know?

"By usual metrics, such as the ratio of prices to incomes, the ratio of rents to mortgages, and the ratio of current prices to expected ones, some areas of the country still look pretty bubbly.

In the decade ending August 2008, according to S&P Case-Shiller data, house prices in New York metropolitan area leaped by 2.2 times, though incomes grew only modestly. The Washington, D.C. area experienced a 2.1-fold jump -- while non-bubbly areas like Cleveland saw an increase of a mere 1.17 times, which is consistent with incomes and inflation.

The median family income in Allentown, Penn. is $46,400, and the median home price is $125,000, meaning houses tend to cost 2.7x the median income. Compare that to San Francisco, where homes consume a whopping 11.6x the median annual salary. "

What if the usual metrics are wrong? They are failing to figure in demographic changes, regulation changes, wealthier people moving and concentrating in new areas where they drive up the prices,etc.? The real world metric is simply whether or not people can afford their houses. Is that metric written in stone?

"Robert Shiller, who teaches economics at Yale University, has calculated that housing prices have remained remarkably constant from 1890 through 1998, rising only 13 percent when adjusted for inflation -- through world wars, the automobile, and the rise of the two-income family. When the dot-com bubble burst, money flowed into real estate, encouraged by the Federal Reserve cutting interest rates more than prudence allowed. "

The Spigot Theory again. What does "more than prudence allowed" mean? Let's say it made it easier to fund a mortgage. Did that automatically lead to irrational and asinine lending practices?
What's the connection between low interests rates and fraud and stupidity? Is there a law for that? I'm trying to understand this phenomenon in a way that explains the way actual human beings act. Oh my God, interest rates are low, let's throw caution to the wind.

"Which brings us back to a taxpayer-funded "rescue" of homeowners. It's true that many people who bought homes in the last decade acted responsibly, made sizable down payments, and purchased a house within their means; they owe more than they paid through no fault of their own.

On the other hand, many people were speculators, fibbing about their income, lying about their assets, and treating their house as an ATM to finance cruises and flat screen TVs. Many banks were in on the game, knowingly placing people in homes they couldn't afford. Even if a bailout is justified, Washington is in no position to determine who's deserving and not. Any bailout punishes renters and Americans who were fiscally responsible by taxing them to benefit those who weren't.

Prices in some areas need to fall, and the market needs to return to normal. Eventually it will. All Washington can do is prolong the pain. "

Is a mortgage deduction taxpayer funded? My problem with this analysis is that it assumes a model of the economy to be the real economy, which has recently been proven to be a less than perfect mode of analysis. At any point in time, there are all kinds of competing incentives and disincentives moving people's decisions this way and that. It might well be that the government will, to some degree, "prop up" home prices in some theoretical model sort of way. But, on the other hand, if the people buying the houses today can afford to buy them and do, then the prices were not artificially propped up, and, even if they were or are, if people can and do freely purchase them, then the market worked. The market only fails if a significant number of people default, since there will always be some defaults. Does he really believe that new buyers, in this market, are radically prone to default?

Do I support the Fed's actions? Not really, no. But I understand what they're trying to do, and am not so sure that it can't work because of a theory I hold, however dearly.

Of course, I'm talking about houses. What works for tulips, I haven't a clue.

"I distinctly remember that, while writing this, I feared criticism for gratuitous alarmism. "

Robert Shiller in the NY Times:

"Speculative bubbles are caused by contagious excitement about investment prospects. I find that in casual conversation, many of my mainstream economist friends tell me that they are aware of such excitement, too. But very few will talk about it professionally.

Why do professional economists always seem to find that concerns with bubbles are overblown or unsubstantiated? I have wondered about this for years, and still do not quite have an answer. It must have something to do with the tool kit given to economists (as opposed to psychologists) and perhaps even with the self-selection of those attracted to the technical, mathematical field of economics. Economists aren’t generally trained in psychology, and so want to divert the subject of discussion to things they understand well. They pride themselves on being rational. The notion that people are making huge errors in judgment is not appealing."

Fine. People get carried away.

"I gave talks in 2005 at both the Office of the Comptroller of the Currency and at the Federal Deposit Insurance Corporation, in which I argued that we were in the middle of a dangerous housing bubble. I urged these mortgage regulators to impose suitability requirements on mortgage lenders, to assure that the loans were appropriate for the people taking them."

Great. Suggestions:

The lenders should make sure that the borrowers can repay the loans.

That's it. Brilliant. And the answer is that people get carried away. Sorry. Not buying it.

You need to assess what allowed people to make serious errors in judgment. I would argue the system of implicit and explicit government guarantees underlying our system, and they way that they were structured. Too many people are getting a free pass appearing far sillier than they really are. They took risk, but it was not totally insane, given that our government always comes to the rescue. You can only determine suitability against the risk taken, and the risk is what needs to be clarified.