In Krugman v. Rajan, I Side with Rajan

Paul Krugman has a book review on three books about the causes of the financial crisis and/or ways to get the economy going again. One of the books is by Rajan, Fault Lines, a book I commented on favorably in an earlier post. As might be expected, Krugman is critical of Rajan whereas I was not. Rajan has a response to Krugman also. Rajan's criticisms of Krugman's review I think are exactly right.

Krugman discusses four causes of the housing bubble that economists and others have identified. The first is the low interest rate policy of the Fed through most the the 2000s. Second, the "global savings glut." Third, financial innovations, and finally government programs.
Rajan cited government policy and the low interest rates in particular. Krugman rejects both, and argues instead for financial markets and a "Minsky moment."

Krugman's arguments that Fed policy and government policies were not responsible are specious, as Rajan shows. Krugman says the Fed couldn't be responsible because there were housing bubbles in Europe also and the European Central Bank was not pursuing low interest rates like the Fed. But, as Rajan notes, the Fed pushed the interest rate to 1% and the European Central Bank to 2%, so both were low by historic standards. Krugman aruges that Fannie and Freddie were not responsible for subprime mortgages, but they were part of the overall government emphasis, regardless of political party, to extend homeownership.

This review by Krugman is further evidence that Krugman has ceased to be an economist and is a political columnist instead. The evidence he cites to back his claims or refute other claims would not be accepted by most teachers if offered by their students. Krugman is so obsessed with showing that Republicans are at fault for all the ills and Democrats are not, that he seems to be identifying and interpreting evidence through biased eyes. As Rajan notes, government officals of both the Clinton and the Bush administrations were involved in policies that help bring about the bubbles and the crisis.

On Floyd Norris' Book Selections

In the business section of the New York Times on Christmas Day, Floyd Norris offered a short list of the best books in 2009. The list contains six books:

--Liaquat Ahamed, Lords of Finance: The Bankers Who Broke the World.
--Robert J. Barbera, The Cost of Capitalism: Understanding Market Mayhem and Stabilizing our Economic Future.
--Johan Cassidy, How Markets Fail: The Logic of Economic Calamities
--Justin Fox, The Myth of the Rational Market: A History of Risk, Reward and Delusion on Wall Street.
--Frank Portnoy, The Match King: Ivan Krueger, The Financial Genius Behind a Century of Wall Street Scandals.
--T.J. Stiles, The First Tycoon: The Epic Life of Cornelius Vanderbilt.

(Note that all six titles of colons and subtitles.)

I have not read the last two books and am not interested in them as far as the recent recession and financial crisis is concerned. Ahamed's book is fascinating, describing the relationahsips among the key central bankers in the years leading up to the Great Depression. I recently finished reading The Myth of the Rational Market and am ready to read How Markets Fail. The book by Fox focuses on the idea of efficient markets in finance. It is good in that it describes the theory relatively well, and presents some interesting anecdotes about the famous economists and finance professors who developed and tested the theories. But, Fox rejects efficient markets, and is much more favorable to behavioral finance. For all the labors he goes through, his bottom line solution is, "It leaves us with a need to find ways to temper speculative excess while acknowledging that we won't necessariyl be able to distinguish speculative excess from an entirely sustainable boom." (p. 319). Very helpful. With that we should be able to have a bright and riskless future.

In skimming through the introduction to the book, How Markets Fail, the topic is broader than the stock market, but looks at people like Hayek, Friedman, and others who advocated free marekts as the best way to organize economic activity. Cassidy also discusses behavior economics, but seeks to offer a broader critique that he calls reality-based economics. He criticizes the Fed for not trying to pop bubbles earlier.

This last point is interesting because it is a topic the members of the Open Market Committee had discussed. It is also a topic in Lords of Finance. Benjamin Strong, who was President of the New York Federal Reserve Bank until is death shortly before the stock market crash, believed there was a bubble but that the means that would be used to pop it could cause a big crash and a depression. After his death, the key decision makers in the Fed tried to pop the bubble, and we had a big crash and a severe recession. No one knows what a concerted effort to pop the housing or stock market bubbles in 2005 or 2006 would have brought about. Perhaps a less severe recession, and perhaps just as severe a recession only sooner.

I also have not read The Cost of Capitalism, but Norris describes it as an attempt to exlain the importance of Hyman Minsky and to demolish neoclassical economics. I have recently read Minsky's, Stabilizing an Unstable Economy (no subtitle). I found Minsky to be difficult to read--not because the ideas or writing was difficult but because I found so much of it to be nonsense. He described the period from 1946 to 1966 as one in which the U.S. had a stable economic and financial system, and that it has become more unstable since then. The reason for the increasing instability is financial innovation. In the end, he calls for a much larger role for government to keep the system more stable. I suspect that Minsky would have argued that he paid more attention to historical realities than traditional economists. I am not sure that is true though.

Many people around my age (baby boomers) recall the time Minsky said was stable in nostagic terms. The U.S. economy was strong and American firms dominated the world's economy. This was the time period when things were normal. But this is false; it was a time of abnormality. World War II left Europe and Japan in shambles. It took time for these economies to recover and rebuild. It took time before they could compete with American business. The world economy became more normal in the sixties.

There is another historical dimension glossed over by Minsky--the actions the government was taking. Lyndon Johnson won the presidency with a huge mandate and a Democratic Congress. He pushed for more government involvement in the economy through things like Medicare and the war on poverty. Meanwhile, we also had an actual war in Vietnam than picked up steam. The resulting pressure on prices led to the Fed mostly accommodating the fiscal policy, but sometimes trying to reduce inflation. The end result was often a stop-start monetary policy that saw inflation and unemployment increasing. The continued conflicts in the Middle East and the new-found power of OPEC led to large increases in oil prices. U.S. labor markets experienced a huge influx of young workers as baby-boomers entered in large numbers, and as women began seeking long-term careers rather than jobs until marriage and children. Minsky makes no reference to any of these changes in the U.S. that surely had repurcussions on the stability of the economy.

So, I must disagree about the greatness of several of the books selected by Norris. (I'll offer my own list in a later post). But I would like to finish the lengthy post with one other observation. The Federal Reserve was created in 1914 after the turmoil of the Panic of 1907. The Fed was supposed to make such panics a thing of the past. Yet, twenty-five years later we were in the worst depression the country ever experienced. Many economists blame the Fed for the severity and length of the depression. If people followed the pattern of many books today--the recession we just had shows the bankruptcy of economics and of markets. One could have concluded with better justification for the argument in 1930 that the Fed failed so miserably that it should have been disbanded.

Root Causes of the Economic Crisis Continued

In an earlier post (Oct. 1) I mentioned an article in the Journal of Accountancy that I thought was very good about the root causes of the economic and financial crises and the recession. I also noted that Marty LaBarge and I had written a comment on the article and sent it to the journal. The comment, divided up by questions supplied by editors, is part of an "Economic Discussion" on the original article. It is available, along with other comments on the original article, on-line here. My only complaint is that they left in our reference to a figure we supplied on US net exports but didn't publish the figure.

Root Causes of the Economic Crisis

There is an interesting article on the root causes of the economic recovery in the October issue of the Journal of Accountancy. I think it is correct in its assessment of the crisis. My colleague, Marty LaBarge, and I have written a comment to it, in which we agree with the article but offer a little more information about the international dimension of the crisis. It can be found here.

Thoughts on the Economic Crisis, II

In my previous post, I concluded that given the complexity of the problem associated with the high degree of specialization of labor that prevails today, one might expect chaos to rule. Yet, it does not. In fact, when the economic environment becomes relatively more uncertain and chaotic, it is called a crisis.

Anyone who has had a basic economics course can recognize that we do not have persistent chaos because the market system functions well most of the time. The prices of goods reflect relative scarcities of goods and services. If people want more pencils than they had previously, the price of pencils increases indicating that pencils are now relatively more scarce. The higher price is a signal to pencil producers to find additional resources and produce more pencils. By doing so, their profits increase. The higher profits, if large enough and sustained enough, may even induce an entrepreneur to enter the industry and begin production of pencils. A natural disaster such as a hurricane that destroys homes and businesses creates a need for resources to be reallocated so that the area that was destroyed can be rebuilt. Again, price changes can provide the signals needed to induce people in other parts of the country to reduce consumption of materials and to induce building supply companies to increase production of lumber, shingles, and so on.

The term "invisible hand" is used to represent the process by which markets operate in an orderly manner. Another term sometimes used to describe markets and some other systems is spontaneous order. That is, order is arrived at spontaneously and not as the result of deliberate and planned actions of a group of people. The order achieved evolves over time through the development and evolution of institutions such as contracts, firms, non-profit organizations, co-ops, courts, government agencies, and so on.

But what about times of economic crisis? The market system would seem to take care of equilibrating quantities of demand and supply in most markets for goods and services. Price changes that signal changes in relative scarcity provide the correct information and signal. A natural disaster--hurricane, drought--can cause a problem for awhile, but the system should adjust over time. So, crises can be related to supply shocks to the economy. The bigger the shock the bigger the problem. Yet, if we just look at the real economy, the markets should correct themselves given some time. So, what else is needed to have a serious economic crisis?

Money is a complicating factor. The price signals mentioned above refer to "real prices" or to "relative prices." If the price of lumber increases, we mean to say that the price of lumber increases relative to the prices of other goods. But if there is money in the economy, then it is possible to have price inflation or deflation. If the inflation is anticiapted and if all prices go up by the same percentage, inflation should not add to the problem. However, that is not the way inflation works. Instead, some prices go up by more than others and the price changes come at different times and with different frequencies. Now if the nominal price of lumber increases 5 percent, it could be associated with a real price increase of 5 percent, or more than 5 percent or less than 5 percent. In fact, it could actually be a price decrease in real terms if all other prices are going up by more than 5 percent. The signal used in a market economy to indicate changes in relative scarcities is less informative in the case of inflation. People are more likely to make incorrect decisions because they interpret a 5 percent increase in the price of lumber as indicating that lumber is now relatively more scarce and should be economized more, when in actual fact it may be relatively less scarce. The more variable the inflation rate the more difficult it is for people to know what is going on in the marketplace.

We see then that an economic crisis can be related to incorrect monetary policy. This is not the end of the story though. We still need to consider the effect of time on the stability of a market economy, and this will be the topic of my next post.

Thoughts on the Economic Crisis, I

It's a financial crisis!
It's an economic crisis!
It's a failure of unregulated capitalism!
It's the end of the Reagan Revolution!
It's the worst since the Great Depression!

All of the above are statements one can hear describing the current economic situation. The use of the term crisis indicates that we are in a situation that is not normal. The third statement indicates that capitalism as practiced in the U.S. (as well as the U.K.) has failed because of lack of government oversight and regulation. The fourth statement suggests that the Reagan Revolution brought in unregulated capitalism and this has failed. The last statement is ubiquitous, but also indicates that things are really bad with the suggestion that things may get worse.

I want to examine things from a different perspective. Actually, I want to begin with Adam Smith and the key idea that specialization of labor is productive. What does this mean? At a minimum, it means that most of us produce goods or services that we do not consume or utilize and consume goods and services that we do not produce. This specialization is productive so that we can have much higher standards of living than if we were totally independent. In fact, most of us probably wouldn't survive long if we could only consume and use goods and services that we produced ourselves.

There are costs associated with specialization of labor. For one thing, the actions of different people need to be coordinated. If I don't make my own food, I have to rely on others to do so. All the things produced by producers are meant for consumers and the goods produced need to get to the consumers. The wants of consumers have to be communicated to the producers. Further, a form of exchange is needed. In a very simple economy, barter can be used. Another possibility is to have someone responsible for collecting all the goods and distributing them to the members of the simple economic system or society. When humans were organized in small tribes, this method may have been used. But, as societies get larger and specialization of labor gets more complex, these simple methods don't work well. Some medium of exchange--money--is needed. Adding money to the mix also adds complexity and potential problems. Is the quantity of money appropriate for the number of transactions that will be made. Who is responsible for producing the money? Who determines what money is? More questions could be added.

Another complicating factor is that we live in a world of space and time. Production takes time, whether we are talking about planting corn in the spring and harvesting it in late summer, or building a house. Further, some goods we produce are durable and provide services for a long period of time. Some goods are produced to increase future production but not for consumption. These investment goods include most of the capital goods in factories. A decision to start a firm to produce pencils involves purchasing inputs from many different parts of the world, building capital goods that are used to perform many of the steps in pencil production. (A description can be found in the interesting book, The Pencil: A History of Design and Circumstance by Henry Petroski. Available at Amazon.) To start a firm making pencils requires spending a lot of money to obtain the needed inputs, capital goods, and to support oneself while waiting to obtain revenues from pencils that will be sold eventually. This is where finance comes in. The people with the entrepreneurial spirit to start a new firm, the ideas that may be commercially viable are not always people who have savings to live off of while the plans come to fruition. Financial markets transfer funds from savers to investors. But, the investor may or may not succeed. The investor is counting on people wanting to buy his or her product in the future for prices that will cover all of the costs incurred by the investor. The future is unknown. Hence, many investment plans fail. Many new firms fail.

Given these complexities associated with specialization of labor and time, it would be easy to think that we would have chaos unless some very wise people were consciously and actively coordinating everything. That is, isn't it inconceivable that hundreds of millions of people can make decisions on their own about what to consume, where to work, what to make, what to save and invest, how many children to have, etcetera, etcetera, etcetera, could actually function? From this perspective, any situation that is not an economic or financial crisis would appear to be the abnormal situation. We should always be in crisis.

I will elaborate further in a later post.

Are the "Generals" Remembering History or Fighting the Last War?

The current economic and financial crisis has generated a lot of discussion about previous recessions as well as the Great Depression. Clearly, the approach taken by the federal government and many prominent economists is to take from Keynes the idea of government spending as a stimulus and replacement for reduced consumer spending and reduced business investment. There has been a lot of work over the past decades devoted to understanding the causes of the Great Depression and possible remedies. In this sense, people seem to be paying attention to the adage from George Santayana, "Those who cannot remember the past are condemned to repeat it." Yet, each crisis is different in the sense that the institutional structure of the economy is different, the international setting is different, and technology is different. It is often said that generals have a tendency to, "fight the last war." If we consider the post-World War II recessions as "police actions," then we may be fighting the last war rather than remembering history.

"Worst since the Great Depression"

In a speech before the Brookings Institution on March 9, 2009, Christina Romer said that she has been uttering the words, "worst since the Great Depression" far too often. She is not alone. The words have been uttered by many politicians, economists, financial analysts, and just about everyone. The economy is down and seems to be sinking lower. Whatever measure we might use--unemployment, foreclosures, consumer confidence--we see a gloomy picture.

How are we doing on crisis management? In my view, not well. First, the economists. Keynesianism dominated the profession in the decades following World War II. Many economists believed we could fine tune the economy and select the level of unemployment that was associated with full employment by accepting a certain level of inflation. The stagflation of the 1970s destroyed that rosy view. Work by macroeconomists, both at theoretical and empirical levels, led to a rejection of the view that the answer to a recession was to increase government spending. The short-run multiplier associated with government spending was not that large, and the long-run effects tended to be nil or negative. In the current crisis, many prominent economists are arguing strenuously for massive increases in government spending. Let's return to the macroeconomics of the 1950s and 1960s and ignore everything we have learned since the 1970s. Since this is the "worst since the Great Depression," let's revert to depression-era thinking.

Second, the politicians. There has been a lot of talk about needing bipartisan solutions and approaches to government. Both parties have failed at crisis management. The crisis began as a credit crisis and a solution to the banking and financial sectors is needed. But the "fixes" for the financial sector have been inadequate and inconsistent. For all the talk of bold action, there has not been outlined a bold, consistent procedure to deal with the balance-sheet problems of banks. The stimulus plan includes many items that cannot be considered stimulative but actually represent the pent-up demand for programs favored by Democrats. Let's add autos to the mix, but also tell the auto makers how they should run their firms. Certainly a senator or representative knows more about making and selling cars than people who have worked in the industry for decades. It is easier and more fun to tell people how to run their businesses, or to fulminate over executive compensation, or to pass spending bills than to think seriously and hard about how to recapitalize banks and restore confidence in the financial sector.

Third, the public. You and me. We want quick answers. We want a riskless future and only good times. We want to be able to spend and buy any gadget that interests us without worrying about saving for the future. After all, rising home prices and equity prices should take care of our retirement. Oh, along with social security, medicare and senior discounts. We want it all!

Economics recognizes that we cannot have it all. There are opportunity costs to decisions and choices made. Choices have consequences, often unintended. Just because this is the "worst ______________ (fill in with your preferred term) since the Great Depression" does not mean that the choices we make will not have costs or consequences. Let's come out of the recession with more reasonable spending and saving decisions, and with an awareness that we cannot eliminate risk. We cannot have it all.