Comment on Professor Bradford DeLong's article "Stimulus Ostriches" on Project Syndicate
(Date written: March 9, 2009)
The liberals are facing increasing opposition to stimulus spending because of several fallacies in their argument. I have analyzed two of these fallacies here:
(1) Quoting Keynes to claim that if the stimulus package is not large enough, it could not deliver a recovery.
There is no provision in Keynesian theory that says one can spend several trillion dollars today in order to postpone a recession by a decade. As I explained in an earlier posting, the market mechanism, even in its most efficient functioning, tends only towards a random walk of price movements. Whereas in the functioning of the economy, most day-to-day decisions are made based on assumptions of continuity. Because of this fundamental discrepancy, the allocation of resources that the market mechanism makes in the short run, may not turn out to be optimal in the long run. Hence there is a role for an external agency, like the government or the central bank, to step in and take corrective measures whenever it is obvious that the functioning of the markets would not be optimal in the long run.
Now, the only tool that Keynesian theory provides for looking into the long-term future is time value of money. To wit, it was by employing this tool that Keynes envisioned "Economic Possibilities for our Grand Children" in 1931. The rationale Keynes provided in that essay for time value of money to stay above inflation, was that a 2% annual growth in productivity seemed a safe assumption, in view of technological progress in recent centuries. At the macro-economic level, the procedure by which policy makers can ensure a positive inflation-corrected, time value of money is to aim for a positive inflation-corrected growth rate in annual GDP. The most effective way to do this in a market-based capitalist economy is, of course, to let the markets do their work.
But, as explained in the first paragraph, Keynes identified that the market could be malfunctioning sometimes, at which times corrective measures from the state and the central bank are needed. The state's role could be to spend money in order to sustain consumer demand and to reduce unemployment to the extent possible. Thus Keynesian theory advocates a constant monitoring of the economy to ensure that the functioning of the economy is made close to optimal, with co-ordination between the markets, the central bank and the state. Keynesian theory does not prescribe a one-time huge spending to avoid all possible troubles in the next decade.
Now, in recent decades, a lot of research papers have been written exploring the possibilities of smoothening the fluctuations in the business cycle and even further, of avoiding a recession altogether. This line of investigation gains credence especially in light of East Asia's 25-year long boom before 1997, and the world economy's 63-year long growth without recession, from the end of the second world war to 2008. My own assessment is that due to changes in the circumstances, the assumptions made in these research papers would no longer hold in the current severe crisis situation -- the single major factor being that the American economy cannot be mathematically modeled any longer with the assumption that it is predominantly an isolated entity.
(2) The enigma of the credit crunch.
I had already explained in October 2008 (ref: Question 1 of my "FAQ on the Financial Crisis"), that this current crisis has more to do with the accumulated capital rather than the working capital of the American economy. In particular, I had stated that "the funds available with the commercial banks, community credit unions and credit card companies have been sufficient to keep business investments, payrolls and consumer spending going on in the near-term". In contrast, starting from September 2008 or so, nearly all the liberal economists forecast a massive credit crunch that was to unfold on Main Street. This led to a huge uproar demanding that the Fed cut interest rates quickly, and that the economy be flooded with liquidity. The TARP legislation was hurriedly enacted to enable the government to spend 700 billion dollars at its complete discretion. No consideration was given to the event that an economy going into a recession might not need as much credit. Did the liberal economists plan on avoiding the recession altogether, just by scaring the government into implementing all of their policy recommendations? When the new government took office, the demand from the liberal economists took the form of a massive stimulus package. The spending so far, on account of this economic crisis, has exceeded four trillion dollars and no end is in sight.
Admittedly, I had missed one important point regarding the credit situation in October 2008. To explain this point, let us assume that a Wall Street Investment bank has invested in mortgage securities with a leverage of 24 to 1. This means that the bank's own capital makes up only 4% of the money invested in the mortgage securities. Now, the mortgages on homes are divided into tranches, with the risks of foreclosures reflected in progressively larger proportions as one went lower down the tranches. Assume that the mortgage on a typical home is divided into 20 tranches of equal face value, and also that the bank has made equal investments in all the 20 tranches. Note that this means that the bank's capital of 4% falls just short of covering the lowest of the tranches (the 20th).
Now, the stories heard in the media, if correct, imply that the 'toxic' mortgage securities are trading for 20 cents on the dollar. This already wipes out the bank's capital, if only the lowest tranch (the 20th) is toxic and all the other tranches are trading at full-maturity prices. If the situation is far worse than this, the banks could not have survived for so long, the mortgage crisis having come to light as early as January 2007. The bank's auditors and accounting rules would not allow for losses exceeding several times the capital. So, the banks must be in a situation where only the lowest tranches are trading at fire-sale prices, and the other tranches are valued in the market at close to full-maturity value.
The point I had missed in October 2008 is this: with the situation as described above, the Wall Street banks have an added incentive to simply keep holding their mortgage securities, freezing up their investments, so to speak. This is because their investments in mortgage securities were highly lucrative, in view of their huge leverage ratios. In fact, with the above 24 to 1 leverage ratio, just a difference of 0.8% between the interest rates obtained from the home-owners' mortgages, and the interest rate paid out to the banks' lenders, would ensure that the Wall Street banks recover profits of 20% on their capital. This means that their whole capital would get replenished in less than five years. So every month the banks could just let the profits flow in, and take losses on selling off the toxic assets just enough to offset the profits. If they could do this for a year or two, they could have already sold off a third of their toxic assets, and who knows, by then the economy could have recovered to get much better prices on their securities? Because of this added incentive for the investment banks to hoard their funds, there could be a scarcity of credit. It is this dynamic nature of the profit-inflow/toxic-asset-selloff combination that I had missed in October 2008.
However, even though I had missed this point, I could still see that with the economy going into recession, the freezing up of funds among the investment banks was not the main concern, because of my belief that the crisis did not directly involve the working capital of the economy. Moreover, my solution for unfreezing the credit crunch was to hold a public auction of the mortgage securities directly for the home-owners. The home-owners could purchase the tranches from the security owners on Wall Street, and they could use the purchase towards reduction in their debt. No re-writing of the mortgage contract is necessary. No investment of $700 billion TARP funds is necessary. Neither nationalization nor Good bank/Bad bank is necessary. Moreover, all of these alternative methods do not address the moral hazard problem (The moral hazard is that the home-owners who paid their mortgage dues sincerely are being ignored, and the irresponsible home-owners are being bailed out. On the bankers' side, the moral hazard is that banks who lent recklessly are being bailed out by the TARP and other government funds). Only my solution addresses the moral hazard problem squarely. Lastly, the technology for implementing such a public auction among the home-owners already exists among software companies like eBay, Verisign, Amazon, Google and PayPal. In conclusion, having spent much of their political capital chasing the ghost of credit crunch, the liberals are now finding that the economic crisis has gotten out of hand.
Update:
(i) I did not receive any response from any academic economist about my comment. However, a few days after the above comment was posted, Professor Bradford DeLong took part on a round-table discussion on Economist.com, which was held in response to Professor Dani Rodrik's article in the Economist print issue that global financial regulation should delegate a large part of the supervision to individual nation-states. In his response, Professor Bradford DeLong had criticized this view citing the important role that a global hegemon could play -- betraying a strong bias towards empire-building, in my opinion. An anonymous comment to Professor DeLong's response, from a user named NotAGenius, had this to say:
March 15, 2009 18:43
(Date written: March 9, 2009)
The liberals are facing increasing opposition to stimulus spending because of several fallacies in their argument. I have analyzed two of these fallacies here:
(1) Quoting Keynes to claim that if the stimulus package is not large enough, it could not deliver a recovery.
There is no provision in Keynesian theory that says one can spend several trillion dollars today in order to postpone a recession by a decade. As I explained in an earlier posting, the market mechanism, even in its most efficient functioning, tends only towards a random walk of price movements. Whereas in the functioning of the economy, most day-to-day decisions are made based on assumptions of continuity. Because of this fundamental discrepancy, the allocation of resources that the market mechanism makes in the short run, may not turn out to be optimal in the long run. Hence there is a role for an external agency, like the government or the central bank, to step in and take corrective measures whenever it is obvious that the functioning of the markets would not be optimal in the long run.
Now, the only tool that Keynesian theory provides for looking into the long-term future is time value of money. To wit, it was by employing this tool that Keynes envisioned "Economic Possibilities for our Grand Children" in 1931. The rationale Keynes provided in that essay for time value of money to stay above inflation, was that a 2% annual growth in productivity seemed a safe assumption, in view of technological progress in recent centuries. At the macro-economic level, the procedure by which policy makers can ensure a positive inflation-corrected, time value of money is to aim for a positive inflation-corrected growth rate in annual GDP. The most effective way to do this in a market-based capitalist economy is, of course, to let the markets do their work.
But, as explained in the first paragraph, Keynes identified that the market could be malfunctioning sometimes, at which times corrective measures from the state and the central bank are needed. The state's role could be to spend money in order to sustain consumer demand and to reduce unemployment to the extent possible. Thus Keynesian theory advocates a constant monitoring of the economy to ensure that the functioning of the economy is made close to optimal, with co-ordination between the markets, the central bank and the state. Keynesian theory does not prescribe a one-time huge spending to avoid all possible troubles in the next decade.
Now, in recent decades, a lot of research papers have been written exploring the possibilities of smoothening the fluctuations in the business cycle and even further, of avoiding a recession altogether. This line of investigation gains credence especially in light of East Asia's 25-year long boom before 1997, and the world economy's 63-year long growth without recession, from the end of the second world war to 2008. My own assessment is that due to changes in the circumstances, the assumptions made in these research papers would no longer hold in the current severe crisis situation -- the single major factor being that the American economy cannot be mathematically modeled any longer with the assumption that it is predominantly an isolated entity.
(2) The enigma of the credit crunch.
I had already explained in October 2008 (ref: Question 1 of my "FAQ on the Financial Crisis"), that this current crisis has more to do with the accumulated capital rather than the working capital of the American economy. In particular, I had stated that "the funds available with the commercial banks, community credit unions and credit card companies have been sufficient to keep business investments, payrolls and consumer spending going on in the near-term". In contrast, starting from September 2008 or so, nearly all the liberal economists forecast a massive credit crunch that was to unfold on Main Street. This led to a huge uproar demanding that the Fed cut interest rates quickly, and that the economy be flooded with liquidity. The TARP legislation was hurriedly enacted to enable the government to spend 700 billion dollars at its complete discretion. No consideration was given to the event that an economy going into a recession might not need as much credit. Did the liberal economists plan on avoiding the recession altogether, just by scaring the government into implementing all of their policy recommendations? When the new government took office, the demand from the liberal economists took the form of a massive stimulus package. The spending so far, on account of this economic crisis, has exceeded four trillion dollars and no end is in sight.
Admittedly, I had missed one important point regarding the credit situation in October 2008. To explain this point, let us assume that a Wall Street Investment bank has invested in mortgage securities with a leverage of 24 to 1. This means that the bank's own capital makes up only 4% of the money invested in the mortgage securities. Now, the mortgages on homes are divided into tranches, with the risks of foreclosures reflected in progressively larger proportions as one went lower down the tranches. Assume that the mortgage on a typical home is divided into 20 tranches of equal face value, and also that the bank has made equal investments in all the 20 tranches. Note that this means that the bank's capital of 4% falls just short of covering the lowest of the tranches (the 20th).
Now, the stories heard in the media, if correct, imply that the 'toxic' mortgage securities are trading for 20 cents on the dollar. This already wipes out the bank's capital, if only the lowest tranch (the 20th) is toxic and all the other tranches are trading at full-maturity prices. If the situation is far worse than this, the banks could not have survived for so long, the mortgage crisis having come to light as early as January 2007. The bank's auditors and accounting rules would not allow for losses exceeding several times the capital. So, the banks must be in a situation where only the lowest tranches are trading at fire-sale prices, and the other tranches are valued in the market at close to full-maturity value.
The point I had missed in October 2008 is this: with the situation as described above, the Wall Street banks have an added incentive to simply keep holding their mortgage securities, freezing up their investments, so to speak. This is because their investments in mortgage securities were highly lucrative, in view of their huge leverage ratios. In fact, with the above 24 to 1 leverage ratio, just a difference of 0.8% between the interest rates obtained from the home-owners' mortgages, and the interest rate paid out to the banks' lenders, would ensure that the Wall Street banks recover profits of 20% on their capital. This means that their whole capital would get replenished in less than five years. So every month the banks could just let the profits flow in, and take losses on selling off the toxic assets just enough to offset the profits. If they could do this for a year or two, they could have already sold off a third of their toxic assets, and who knows, by then the economy could have recovered to get much better prices on their securities? Because of this added incentive for the investment banks to hoard their funds, there could be a scarcity of credit. It is this dynamic nature of the profit-inflow/toxic-asset-selloff combination that I had missed in October 2008.
However, even though I had missed this point, I could still see that with the economy going into recession, the freezing up of funds among the investment banks was not the main concern, because of my belief that the crisis did not directly involve the working capital of the economy. Moreover, my solution for unfreezing the credit crunch was to hold a public auction of the mortgage securities directly for the home-owners. The home-owners could purchase the tranches from the security owners on Wall Street, and they could use the purchase towards reduction in their debt. No re-writing of the mortgage contract is necessary. No investment of $700 billion TARP funds is necessary. Neither nationalization nor Good bank/Bad bank is necessary. Moreover, all of these alternative methods do not address the moral hazard problem (The moral hazard is that the home-owners who paid their mortgage dues sincerely are being ignored, and the irresponsible home-owners are being bailed out. On the bankers' side, the moral hazard is that banks who lent recklessly are being bailed out by the TARP and other government funds). Only my solution addresses the moral hazard problem squarely. Lastly, the technology for implementing such a public auction among the home-owners already exists among software companies like eBay, Verisign, Amazon, Google and PayPal. In conclusion, having spent much of their political capital chasing the ghost of credit crunch, the liberals are now finding that the economic crisis has gotten out of hand.
Update:
(i) I did not receive any response from any academic economist about my comment. However, a few days after the above comment was posted, Professor Bradford DeLong took part on a round-table discussion on Economist.com, which was held in response to Professor Dani Rodrik's article in the Economist print issue that global financial regulation should delegate a large part of the supervision to individual nation-states. In his response, Professor Bradford DeLong had criticized this view citing the important role that a global hegemon could play -- betraying a strong bias towards empire-building, in my opinion. An anonymous comment to Professor DeLong's response, from a user named NotAGenius, had this to say:
March 15, 2009 18:43
Thanks for taking time out from losing the debate on Keynesian economics to share your thoughts.
(ii) Date: June 17, 2009. Reading this post three months it was written, it seems that I should explain why I had framed my argument with "There is no provision in Keynesian theory that says one can spend several trillion dollars today in order to postpone a recession by a decade". After the financial crisis hit in September 2008, the liberals were badgering every one with the question why the American economy was not headed for a repeat of the Great Depression of the 1930s. Professor Paul Krugman was the leader of this movement, and he even put up a straw-man and burnt it down. The straw-man was Professor Robert Lucas who had made some statements some years ago to the effect that the risks of the American economy deteriorating to the Great Depression, and their remedies, were well-understood now. It is not so useful to keep dwelling on the business cycle. Economists should concentrate on long-term growth instead. Professor Krugman made an elaborate ceremony of kicking down the straw-man. He even wrote a new edition of his 1999 book, The Return of Depression Economics.
At the same time that the liberal intellectuals were scaring the general public that the American economy was headed for the Great Depression, they were also saying that if the stimulus bill is not large enough, it would not lead to a recovery. Here was the inconsistency. If the existing theories in macro-economics could not explain why the American economy would not continue to deteriorate through the Fall and Winter 2008, and Spring of 2009, how come these very same liberals were claiming that if a stimulus bill, massive enough to their satisfaction, was enacted, there would be a recovery? Suddenly, they were claiming that the crisis is understood well-enough that they could even show us a way towards the recovery. If this was the case, while we are at this recovery business, why not spend several more trillions to postpone the recession altogether for a decade? This was the basis of my argument. As of date, the liberals are still claiming that there are serious risks of the return of the Great Depression.