On the Contrary

Paul Krugman has written an intriguing book called “The Return of Depression Economics and the Crisis of 2008”.  It is an important read for most Americans because it probably says more than any other piece I have read so far about our way forward.  Oh, I know what you are thinking.  “Paul Krugman is that liberal economist who just wants to spend, spend, spend.”    Well that is what he is recommending for our present situation, but unlike most Republicans he doesn’t spend, spend, spend, while cutting taxes.  But this book, whether you agree with his prescription for curing what may become a Depression or not, is more about the state of economics.  He goes through each of the various “cycles” that we have gone through in the last century in the world economy and tries to make sense out of their cause and effect, and the lessons learned.  Since I know that most of you won’t read his book, I am going to try to synthesize the main points (which Dr. Krugman may dispute) which should be non-partisan.

If you read my blog, The Dismal Science, you know that way forward for our present predicament depends upon your political perspective.  The big debate is between tax cuts versus public spending, and how big should the public spending be.  One very enlightening exchange was between Nate Silver of Fivethirtyeight.com and Professor Greg Mankiw’s article in the New York Times on Sunday (Is Government Spending Too Easy an Answer?) where the debate revolved around a study that Mankiw claimed showed that tax cuts are highly effective in producing economic stimulus and Silver claimed this was a complete misreading of the study.  You can read it for yourself, my point here is not who is right (Silver obviously is, but that is my political perspective), but that cause and effect in economics is still being argued and disputed along partisan political lines instead of scientific logic.  For those of you who care, the problem is that there are too many variables so the root cause is always up for grabs depending on which variable you think had more impact.

What Professor Krugman does is try to make sense out of all this mish-mash, and even if you don’t totally agree with his cause and effect analysis, the overall thrust is undeniable if not disturbing.  This, simply said, is that there is a lot more risk in the economic world that we ever imagined, and our ability to control this risk and our economy is a lot less than we imagined.  As we go through each crisis from Japan, Asia, Mexico, Argentina, Brazil, or the United States what we find is ever increasing complexities of investments and financial instruments that are more and more susceptible to controlled or uncontrolled changes in the market.  Currency fluctuations and the attendant currency speculation impact investment viability and financial arrangements.  What becomes most evident is that a fix for one nation’s problem exacerbate another’s.  Add to that the free flow of world capital and what you have is a system that is driven by expectations and confidence, said another way, psychology and rumor.  Where in the past runs on banks could be localized and controlled, massive movement of capital (pulling it out of one market to go after another) is now internationalized and computerized.  The bottom line here is that even normal downturns in the business cycle are now reflected across nations, and in some cases magnified worldwide.

We have assumed that we could control our fate by normal monetary policy (interest rates and liquidity) and we are finding out that these are less effective than we thought in a global market place.  We are finding out that our evaluation of risk in investments is much more an iffy proposition.  We are finding out that things we thought weren’t critical to the safety of our economy (and thus required little or no regulation) can cause catastrophic changes across the entire economy.  If you are a fan of chaos theory, think about this:  predicting weather accurately requires the input of almost an infinite number of variables.  It is not really a chaotic process, just that there are so many variables and their interaction so complex that ignoring just a few throws the whole prediction process off.  Welcome to our complex international economy.

We have allowed the free enterprise system run free, or at least controlled those things that we thought could prevent or reduce the impact of major downturns.  Think about simple things like a Federal Reserve System and Federal Deposit Insurance that prevent bank runs, or keep banks solvent during a run  (even if that run has no rational basis).  While these controls have worked in the past, new markets and their mechanisms may make them obsolete.   If we want a world economy that is less volatile, then we may get a free enterprise system that is a lot less free.  Otherwise we are just starting to see this volatility as a normal part of the business climate.  Businesses thrive when they can control their risk, in other words to have some certainty about their investment.  When they can’t, they withdraw from that market or place marginal bets and that starts the downturn of a cycle.  Controls were designed to minimize these perturbations and they aren’t working.

The real issue with all of this is that there is no real agreement on what steps can be taken to reduce this risk.  We don’t yet know or at least don’t have an agreement on how to fix this volatility, what needs to be regulated and protected, and what doesn’t.  What you are left with is that the old answers that have been our conventional wisdom about our economy may now be obsolete.  Think of Einstein’s Theory of Relativity’s impact on Sir Isaac Newton’s Laws of Gravity:  Newton wasn’t wrong, just overly simplistic as we came to understood the complexity of the universe around us.  As these arguments go on around partisan political ideology, our economy may be truly adrift (My conclusion not Professor Krugman’s).  We are truly in uncharted waters and the way forward is quite unclear.  Depressed Yet?