On the Contrary

If we ever get past this stimulus package thing, then we have to look at how to fix the system that got us into this mess.  This is the first part of that discussion I call Macroeconomics.  The second part will be a look at the latest bubble and how we got into it which I call Microeconomics.

Macroeconomics is defined as the branch of economics that studies the overall working of a national economy or an economy in the aggregate.  But I am going to define it here as capitalism and the reality of its operation in the twenty-first century.  One of the things that should really worry you is that the experts who are providing their advice about what we should be doing about our economy are creatures of the old system.  Their self-interest is to restore the system to what it was because that is what gave them their power, influence, and wealth.  They are looking at what should be done through a rear view mirror.  But some of us think their prescriptions are not recognizing the reality of macroeconomics today.   Some of our basic assumptions about capitalism are basically flawed, leaving us rudderless in an attempt to build a stable economy.

I am basing my own analysis on two really good books about our economy, Paul Krugman’s The Return of Depression Economics and the Crisis of 2008, and George Cooper’s book, The Origins of Economic Crises:  Central Banks, Credit Bubbles, and the Efficient Market Fallacy.  Professor Krugman’s wonderful book takes you through most of the major economic recessions/depressions that have occurred around the world and explains some of factors that either made them worse, had no impact, or made them better.  The conclusion you come away with is that sometimes recovery is just serendipity, our tools for dealing with this crises are becoming less effective, financial instruments and currency speculation has made understanding and controlling the volatility of markets problematic, and world markets and the instantaneous flow of capital due to psychological factors makes risk under appreciated and almost impossible to estimate.  In other words we are dealing with a much more volatile world market than anyone imagined and old ways of estimating risk to provide a stable business environment are ineffective.

Then comes George Cooper’s most compelling argument that markets are inherently unstable.  Conservative economic philosophy (actually most of us believe this) is based upon the idea that markets are inherently stable, that when some external event upsets markets, markets left to themselves will achieve a new equilibrium that maximizes the efficient uses of resources and capital.  This is the basis of laissez-faire economics.  Mr. Cooper argues forcefully that this is not born out by the facts and that markets are inherently unstable and can and will spin out of control.  He makes an interesting distinction between markets for goods and services and markets for assets.  Goods and services markets sell things like shoes or haircuts, and the asset markets sell stocks and loans.

Goods and services markets are self-stabilizing and he uses the example of an increase in demand, say of potatoes, to show how markets adjust to reach a new equilibrium to meet this demand.  Prices rise, stimulating increased production, and new producers and competition meet the need and lower the prices.  Production catches up with demand and prices level to reflect a stable market.  But in the asset market he uses the example of how a large demand can increase the value of assets and with the mark to market approach to measuring value (adjusting worth based on current prices and then adjusting available credit markets to this new asset value), the growth in credit and asset worth is self-reinforcing so that a credit bubble starts to form and unless there are steps to control it, a positive feedback loop expands it until the bubble collapses.  The same occurs when assets are devalued with a crippling shrinking of value, therefore reducing available credit, reducing the value of assets, and the economy is in a self-reinforcing slow down.  He asks the obvious question, if the market were self-leveling, why do we need central banks?

More importantly, the risk models used by almost all of industry are based upon a normal distribution assuming this self-leveling action.  Some economists have claimed that the failure to anticipate the massive shrinking of our economy in our recent mortgage bubble deflation is a “black swan” event (just because you haven’t seen one doesn’t mean they don’t exists and should be included in your analysis).  That is, this one in a kind event was not included in the statistical model.  Mr. Cooper would argue that the whole model is wrong and you have to appropriately model these wild swings as part of the normal fluctuations of the market not some black swan event.

He then takes on the four functions of central banks:

• Restrain monetization (printing money) to control inflation
• Promote monetization to avoid economic contractions
• Restrain credit formation for financial stability (increase interest rate)
• Promote credit formation for demand management (decrease the interest rate)

Get the drift?  There are competing priorities and if you assume markets are self-correcting you will have a different set of priorities (the ones we have had to continue increasing economic growth) than you would if you assume that markets are inherently unstable and need to modulated.  He would argue that in the future central bank priorities would be to both limit downward swings and upward swings with much less emphasis on inflation and increasing demand.

Here is the one other thing to recognize.  Financial markets (capital and loans) were once a small portion of the stock market and are now by far the largest sector.  Yet this sector is the one that George Cooper identifies as the most unstable.  Bottom line is that our faith in the capitalist system as a stable way to promote world growth has been highly overrated.  It is still the best way, but if not carefully modulated it can cause world calamity.

So here is a summary of a new model (mine) for capitalism and its control:

• Capitalism is not a stable system but it is the best one we have
• In order to provide the necessary predictability (or the ability to adequately quantify risk) for business investment, the market is going to have to have many more controls which will make it less flexible, but tolerable
• The stock market is going to have to be much more transparent and the risk models are going to have to be simpler and well understood
• The Central Bank’s function is to limit growth, not always encourage it, so that credit bubbles and contractions do not get out of hand.  This should be its first priority with the other functions much less important
• Markets do not make the best decision about where capital is used and that some planning must be part of the mix (think green energy, if we wait for the markets to decide it is way too late).  Market’s tendency to focus on short term gains have not proven to be strategically wise long term choices
• Balance has to be maintained to allow venture capitalism to take on risk which the new conventional wisdom would think overly risky

These assumptions or new conventional wisdom will not be well received by the conservatives because it says that government really does have a strong role to play in our economy including government spending.  It will limit the amount of profit that is skimmed out of the system by the financial markets.  It will say that except in a few instances, wild profit making will be curtailed for more stable growth.  But considering what the conservative approach has brought us to date, this is going to be quite an improvement.

I will leave you with an interesting thought from Mr. Cooper.  As he looks at our current crisis, he agrees that we have to stimulate spending to stop the downward trend.  But he also feels that the growth in the deficit could be catastrophic for our future.  He says the least damaging way forward in his mind is to pay for it by printing money instead of borrowing (monetization).  This will cause inflation, but that inflation is a way of raising taxes and reducing debt.  Think about it.  Debt in an inflationary spiral is reduced while value is increased.  Say you have a house that is worth $1,000,000 and a debt of $400,000.  If inflation hits, the house value in inflated dollars is now $1,500,000 and your debt is still $400,000.  From the tax point of view, if rates don’t change, you now have to pay more property taxes so from the government point of view they have raised more income to pay their debt which has remained unchanged.  It is an interesting idea to think about.

Now back to the debate on the stimulus package with political hacks, whom have probably not read either of these books, and are telling us our way forward based upon partisan politics.  I feel comforted.  Next up is my take on what really caused the collapse of the economy or as I call it, Microeconomics.  It will be a few days, I still have to finish a couple of books.  And no, I have no economic training, but I did stay at a Holiday Inn Express.