The Keynesian worldview seems to have led to increasing stridency and dogmatism about economic stimulus, which has dominated the headlines for several months. There used to be a joke that you can teach a parrot economics—all it needs to say is “supply and demand.” Now it is even easier to teach a parrot the policy prescription to prevent a major recession: All it needs to say is “stimulus.”
Things have gotten so bad that no dissention can be tolerated. The German Chancellor Angela Merkel was harshly criticized for not going along, at least to the requisite degree, with the stimulus consensus. She stood out as “Frau Nein” until she went along with a “moderate” package.
I am not a macroeconomist. I am not even a financial economist. So much of my reaction to the current financial and economic problem may seem out of step with what most commentators are saying. Yet I think it is important.
Collective Irrationality
The macroeconomic frame of mind is quite peculiar. In the name of the emergency, this way of thinking dismisses most concerns about the efficient allocation of resources and throws almost total emphasis on maintaining levels of expenditure and employment. The implicit assumption is that the central problem is a collective irrationality that inhibits people from spending on consumption or investment. The root of the central problem, conceived in this way, is the initial financial meltdown. This involved a kind of domino effect in which the collapse of the housing market and of mortgage-backed securities, packaged in many complex ways, undermined the liquidity and even solvency of many financial institutions. The system’s ability to provide credit and thus expenditure was compromised, although at this writing the reduction in bank credit available has been relatively small.
Thus the solution, we are told, lies in returning to the status quo ante. Restore the condition of the financial institutions—perhaps by buying toxic assets or perhaps by infusing capital into the institutions. Restore the conditions of the housing market by getting the Fed and/or Treasury to buy Fannie and Freddie mortgage securities, thus sending capital into housing and lowering mortgage rates. Restore the condition of industries with large numbers of employees and others indirectly dependent on them. (So far, the automobile industry qualifies.) In general, restore the pattern of expenditure that prevailed before the crisis.
I realize that no economist believes that complete restoration to the previous situation is possible, but the basic philosophy is clear. Once economic agents believe something like this will take place, confidence will be restored.
The critical issue is this: Has the current situation—triggered by unsustainable levels of mortgage credit and production in the housing industry as well as in other interest-rate-sensitive areas—gone so far beyond its cause that we no longer need to worry about these previous misallocations of capital? In other words, is the correction of the cause now irrelevant to the cure?
Stimulus ex Machina
To discover the answer to this question, let’s step back a bit. We must understand the respective roles of causes and feedback effects. This is the “Keynesian” argument. Suppose a fall or collapse in markets X, Y, and Z causes F (a financial meltdown). Then F itself causes X, Y, and Z to fall further. Some of this is deleveraging, and some is the result of falling confidence in, say, the creditworthiness of counterparties. There is a general lack of clarity about what resources and financial instruments are worth. The future begins to look radically uncertain rather than simply risky. A collapse of confidence thus contributes to a fall in production and employment in areas far removed from the initial bubble-burst. The process is not dampening but explosive in the absence of the deus ex machina—that is, fiscal or monetary intervention.
Now let us imagine a cure that ignores the original misdirection of resources to the degree that it treats the collapse in these markets as mainly due to some exogenous loss of confidence. The Federal Reserve decides, as it actually has, to buy mortgage-backed securities, causing credit to become available in the housing market at lower interest rates. This also causes the prices of homes to stop falling and to begin rising. When will the Fed stop this infusion of newly created money, and hence a relative rise in resources, into the housing market? Presumably it should stop when the sector is brought back to a level that is simply a correction of the previous excess. In other words, the Fed should prevent the additional, “irrational” decline due to “feedback” effects.
Where is the feedback-sanitized point? I doubt anyone knows. Consider what it means to know. The planners would have to know the array of housing prices corresponding to the normal fundamentals of the housing market. This would be the prices that prevailed when the market was not overexpanded. However, it would not correspond simply to the average of recent values because the housing market has been overexpanded for so long. Recently, two economists have attempted to estimate these prices. (“First, Let’s Stabilize Home Prices,” by R. Glenn Hubbard and Chris Mayer, Wall Street Journal, Oct. 2, 2008.) Unfortunately their attempt is marred by the same extrapolation of historical experience that seems to have gone terribly wrong in the assessment of the risk associated with derivatives and mortgage-backed securities. More importantly, however, it seeks to determine normal market prices in the absence of a freely functioning market.
Suppose, however, the Fed is realistic and admits it doesn’t know. It will then simply try to get the housing market (and other similar interest-sensitive markets) to such a point where general production and employment are considered non-recessionary. The standard, practically speaking, will be the status quo ante. This is because of the lack of theoretical-empirical guidance discussed above and because the various sectors, bolstered by various politically powerful pressure groups, will not be satisfied until they are made whole. At this stage we would be left with the unsustainable direction of resources more or less back in place. The direction is unsustainable because, as the original bubble revealed, it was not consistent with the preferences of consumer-saver-investors.
Why it Won’t Work
Therefore the conventional macroeconomic diagnosis and proposed cures ignore many important structural or microeconomic factors, including the following:
1. The “irrationality” is not primarily in the system’s response to the initial financial impulse but in the unsustainable expansion of the housing and other capital markets in the first place. Proposals to prop up the housing market as if its contraction is some kind of unfortunate overreaction are not credible. Too many resources went into the housing market due to the low-interest-rate policy the Fed followed for too long. While housing prices have fallen recently in many markets, they need to fall further. Markets should be allowed to equilibrate.
2. Equilibrium in the housing market would provide greater transparency to the value of mortgage-backed securities. Lack of certainty about housing prices and the ultimate extent of foreclosures only adds to the problems surrounding the illiquidity of these securities.
3. Government infusion of capital with the purpose of restoring the status quo ante ignores the facts: Fannie and Freddie were overexpanded, the domestic automobile industry is a destroyer of scarce capital, some financial firms did a poor job of allocating risk, banks extended loans under the pressure of the government to people who should not own homes, and so forth. Resources were misallocated.
Confidence Follows Correction
Recessions are not simply crises of confidence or of insufficient demand (due to increases in the demand to hold money). They also have their allocational—or microeconomic—aspects. I suggest that these systemic distortions have an important role in creating the aggregate phenomena we are witnessing. To treat these distortions and their cure as relatively unimportant is a mistake. Lasting investor and consumer confidence follows the correction of the underlying causative distortions and does not precede them. In fact, the dominant macroeconomic policy framework does not leave room for correcting distortions at all because its basic theme is to restore, prop up, and maintain the current direction of resources.
The hastily approved macroeconomic schemes of the Bush and Obama administrations will not succeed in promoting lasting recovery because they ignore the microeconomic fundamentals. The direction of spending and hence resource allocation they generate are fragile—they are not consistent with the preferences of consumers, savers, and investors. Therefore, once the putatively temporary stimulus is complete, the corrective forces that are now trying to undo previous resource misallocations will reassert themselves.
In the longer term, the threat of significant inflation looms large. After the U.S. Treasury has incurred the additional trillions of dollars in national debt (at least one trillion in George W. Bush’s response to the crisis and a minimum of one more in Obama’s response) and the Federal Reserve has completed expanding its balance sheet (thus creating new money) by some trillion or more, what will happen? Will the federal government abolish the stimulus programs, raise taxes to pay off the increases in the national debt (or even to service the debt), and cut entitlement programs? The constituencies that will be formed by the stimulus spending will resist. Will the Fed begin a contractionary monetary policy to absorb all the excess money it created in the name of the emergency? That would raise interest rates and the cost of servicing the huge national debt. What is probable is that we will see an effective repudiation of part of the national debt through inflation. The temptation will be all but irresistible to inflate ourselves out of this mess. The economic consequences of the “cure” will be worse than the disease.