Steve - I think there is something you may be missing in contemplating what kind of boom leads to a widespread bust: the role of money/credit created out of thin air (unbacked by production, defined broadly) either through loosened standards of fractional reserve lending or directly by a central bank.

Indeed, without that easy money-from-nothing, while poor investments requiring an adjustment are quite possible, probably even likely, in an economy of even moderate complexity they will rarely be large enough and widespread enough simultaneously to cause a large overall bust. With large amounts of newly created fiat money, the opposite is true.

You're one of the few voices that properly expressed the apparent _inevitability_ of some recessions, in contrast with the straw-man _desirability_ of recession. I think an analysis of the pernicious effect of newly created easy money/credit and the distortion it causes can illustrate why some busts are indeed inevitable.

Re. Krugman's comment on voluntary unemployment, I wonder if there as well he is setting up a straw man. By official definition as used in BLS reports, as I understand it, an unemployed person is someone who would rather be employed but isn't. I haven't heard of anyone arguing that someone chooses to be involuntarily unemployed. Similarly, I haven't heard anyone disputing the notion that there are people that choose to not be empoyed (e.g. retired.) I'm probably missing something.

I also noted in Krugman and DeLong the mocking tone, which is a common response of the orthodox when challenged (it used to be worse, see Galileo Galilei, but I digress.)

I don't think Krugman has been to Canary Wharf. When I was down there for lunch last week, a friend excused himself for 5 minutes to pick up his Citi redundancy package, mused about how he'd really just been overpaid to build simple data entry apps over&over again, then talked about getting back to scientific computing and data analysis.

Another friend of mine moved from modelling brain functions to modelling with profits insurance bond portfolios. Not sure if he's moved back again yet :-)

<i>doesn't explain why there isn't mass unemployment when bubbles are growing as well as shrinking </i>

The two reasons seem to be:
1) monetary dilution ( the bubble growing) happens gradually. Contractions happen suddenly.
2) During a dilution, businesses can pass increased input prices onto the consumer. During a contraction, businesses cannot pass lower prices back onto creditors. Thus, businesses (and consumers) go bankrupt and unemployment results.

<i>doesn't explain why recessions reduce unemployment across the board, not just in industries that were bloated by a bubble.</i>

The bubbles causing the business cycle are always credit bubbles. Credit is so widespread a credit contraction affects most industries.

Steve-

The basic problem with both bonds and stocks is that people have been buying them as collectibles, not as cash flows. IE - people buy a stock with the intention of selling it to someone else, not with the idea of making money off of dividends. Or people buy a share in a money market fund that holds long term bonds with the intention of selling the shares to someone else, not the intention of holding the bond to maturity.

A collectible is valuable precisely because everyone else also believes it is valuable. Thus the retail investor is being smart and rational.

The problem is that bonds and stocks should not be trading as collectibles. People should only invest based on expected cash flow. But from 2000-2007, the combination of rapid monetary dilution, artificially low interest rates, and a flat yield curve thanks to maturity transformation, resulted in CD's being a terrible investment. Any item with a fixed supply - stocks, gold, and some real estate - was a much better investment. Of course, when the dilution turned off, stocks became a terrible investment, and CD's became a good investment.

The real solution is that the government needs to stop diluting the money supply.

"The obvious answer is that when there is a boom, entrepreneurs know into what sector resources must be reallocated, and pull already employed workers from existing jobs into the new big thing. "

Might it be, that during a boom, workers are more fungible? Take real-estate during the boom. Basically anyone could sell real estate or become a loan officer, so it is easier to switch labor into "boom" sectors. In a bust, workers are less fungible, because there is no more "easy money".

Krugman has a couple of good points in his critique of "hangover theory" - it's difficult to argue that allocative efficiency requires unemployment during a bust but not during a boom and also that it's impossible to ignore the fact that recessions generally create unemployment across the board, not just in the boom industries. However, he's completely missing the boat in assuming that booms (or at least steady growth) can be sustained forever through the right combo of monetary and fiscal policy.

I disagree with your comment on economics needing more "morality". Whose morality is needed? Aristotle's? Plato's? Kant's? JS Mill's? Ayn Rand's? You'll need to define "morality" first before we can talk about whether we need more of it.

If anything, we need to purge economics of morality. Hangover theory can be analyzed in a completely amoral manner. You mentioned Minsky (one of my favorite economists) so we can start by looking at the situation with a simplified Minskyan framework:

-- Financing is a necessary precondition for investment which is a necessary precondition for additional production.
-- A large portion of financing takes the form of debt.
-- Debt is a contractual commitment to make future payments denominated in nominal (rather than real) terms.
-- Firms assume debts today based upon the cash flows (profits) they anticipate their investments will yield in the future.
-- The future is uncertain and expected cash flows may not materialize.
-- Debts must be serviced, even if realized cash flows fall short of original expectations.

Define the bust as the period of time following the realization by firms that their ex-post actual profits are falling short of the ex-ante expected profits used in making the debt-financing decision.

Now you have fixed debt service payments, and cash flows inadequate to meet them. Firms react by aggressively cutting costs (laying off workers, suspending new capital investment) to get economic profits back in line with debt service. Unfortunately, this reduces income to households (hey look, there's that missing microfoundation, no assumption of sticky wages needed) which reduces demand for products, and in turn firms' economic profits. Eventually (this is a dynamic rather than static process) balance sheets are repaired, firms begin making investments (in labor and capital) again, incomes rise and the boom begins (as Minsky would say, "debt financing is once again validated by economic profits"). There's your theory of the endogenous business cycle. And it is very much a cycle. Unless, deflation sets in, in which case the nominal nature of the denomination of debt service creates a positive feedback loop and you end up in a depression.

since it is both the sensed presence of adequate demand and the pressure of wage-costs that motivates renewed investment in capital stocks. It's doubtful, to me at least, that “private” markets alone and unassisted would bring about any timely recovery, rather than tending to adjust to a lower “equilibrium” of ouput to “conserve” capital. Both public regulation,- (since the excesses at the end of the boom likely will reveal new forms of market-failures, especially since markets have restructured and innovated in practices during the boom, leading to a need for regulatory catch-up), and public investment, both to maintain employment/demand, (since many sectors, though perhaps over-extended during the boom, remain sound), and to support and stimulate the discovery of new avenues of real capital investment. (Indeed, given both the high costs and uncertainties of long-run fixed capital investment and the permanent potential gap between increased output and lagging wage-based demand, I would see public investment in some degree continuously and not just cyclically needed).

Where my roughly Post-Keynesian account of the business cycle differs from the likes of Krugman, the New Keynesian neo-classicals, is that I reject the appeal to “general equilibrium” as identifiable with the optimal state of the economy as a whole. To the contrary, long-run dynamic disequilibrium, due to the changing ratios of inter-sectorally balanced reproduction and the gap between increased output and lagging wage-demand renders the notion of a general equilibrium tendency moot, in my view. “Equilibrium” is an analytic device more than a constant reality, and the notion that all markets of whatever sort would clear simultaneously with respect to all other markets is a scarcely plausible fiction. (Indeed, due the the predominant role of oligopolies, the notion of competitively determined prices at the margin clearing markets at equilibrium is dubious, more the exception than the rule, and not a clear standard of value by which nominal prices could be identified with underlying values, since oligopolies restrain competition and set many prices through administrative and market-manipulative procedures. Hence it's not clear that industrial markets simply “clear”, nor do largely fictitious notions of the “labor market” guarantee “clearing”. At any rate, the core neo-classical account of distribution as being determined by the “marginal products” of the “factors of production” has long since been shown to be logically incoherent as an account of the economy as a whole, which the New Keynesians know and ignore). If “general equilibrium” were anything more than an a priori assumption for an approach to analysis, then to be an applicable concept, it would have to specify criteria for when general equilibrium obtains and when it does not, other than ex post. (Indeed, I think that the GE assumption, which manages to rationalize any state-of-affairs as optimal, if it obtains, goes to accounting for why most mainstream macro-economists failed to foresee, let alone forecast, the current crisis, when many common-sense observers were well aware of the growing bubble imbalances and the impending potential for debacle). Rather than imagining that “general equilibrium” as a state-of-affairs that can readily be restored due to market-tendencies,- (as if production systems and their differing forms of constraints could be collapsed mathematically into models of market exchanges, since, while markets might stimulate and promulgate innovations in the production sphere, they themselves produce nothing and do not determine prevailing technical conditions, and as if different types of markets and different market structures were all subsumable into a generalized notion of markets),- I would see an economy as a complex tangle of interlocking feed-back loops between different organizations, with equilibria designating the constantly adjusting feed-back control mechanisms of the interacting organizations. If there is a booming, innovative sector of real capital investment, it tends to spill-over into other more conventional sectors, generating a “virtuous cycle”, (though perhaps a rolling spiral would be a better image), of positive feed-back between interlocking nodes, and sparking a generalized boom, so long as re-adjustment processes that maintain inter-sectoral balances are effective. When the sectoral innovation boom reaches its limits, together with any other innovation boom that it might have sparked in other sectors, (since the underlying technical possibilities that condition economic growth themselves tend to come in interlocking complexes, though there is no way, economically, to predict, nor guarantee such technical possibilities, or their constraints), then an increasing number of interlocking nodes start to spiral downward through negative feed-back, and a recession of one degree or another of severity starts to take hold, spilling over into other more conventional nodes, as diminishing demand stimulus reduces profits and imperils credit. Market “clearing” operations take hold, liquidating excesses from the boom, but also tending to enhance the concentration of capital and oligopoly power, sending the economy into a sub-optimal stagnation “equilibrium”, with any way forward unclear. The paradox here, if there is one, is that wage-income needs to be supported through re-distribution, even as capital “values” diminish, and new avenues of productive investment need to be discovered and opened up, even as diminishing capital “values” shrink from further investment, in order to retrieve still valid sectoral capitalization “values”. But I don't think that such a problematic can be articulated in a GE framework, as mere “stablilization policy”, since it's precisely the prior unstable “equilibrium” that has collapsed, and a new one that needs to be found. Which, of course, would re-start the business cycle all over again, to the point of its subsequent collapse. And then there is the inherent tendency of business cycles to increase the concentration of capital and oligopolistic market-power, which is precisely, through the capture of rents that valorize their capital positions, what tends to freeze up the required re-distributions and re-investments. (Which is why a firm regulatory hand is needed, to unlock such frozen rents. My own view is that banks need to be nationalized, re-capitalized through public funds, with insolvent ones quickly shut down, ailing, but solvent ones revived and solvent ones- mostly small community banks- let be, with senior bond debt correspondingly converted to equity, and capital requirements raised, with risk weightings tightened and reduced, thereby shaking out all the bad “assets”, to be pooled into a “good bank/bad bank” scheme and run-off, at the expense of prior equity-holders, followng which the “shadow banking system” can be taken down, against strengthen bank capitalization, and the whole financial system should be re-regulated and broken up, to eliminate the too-big-to-fail-or-succeed syndrome). Any conception of GE, which would leave oligopolistic concentrations of production/market power in place, (let alone their prolongation into political influence/power), without any countervailing public regulatory, fiscal, and investment policies, strikes me as a counter-productive rationalization of a declining status quo. On the other hand, “free market” fantasies, as resolving crisis tendencies, strike me as more ludicrous than malign. But at any rate, the core neo-classical attempt to reduce economic “value” to nominal prices, a version of positivism, strikes me as not only missing the crucial distinction between the sphere of production and the sphere of circulation, however cross-implicated they may be, but as biasing the whole account toward the financial, rather than productive, economy, by means of assuming a continuity of nominal prices between the two, rather than acknowledging an endemic gap.

Just a few more stray comments on the Austrians. I find the serious Austrians,- (as opposed to recent graduates of the Von Mises on-line Bible college, and self-righteously libertarian, rather than classically market-liberal, fantasists),- going back to Boehm-Bawerk, interesting, though completely wrong. Interestingly wrong, since they at least serve to bring up core issues. And I find myself in ironical agreement with certain of their narrowly-tailored points. But it's nonsense to claim that all-our-woes are due to fractional-reserve banking, (since that was baked-into-the-cake long before the rise of industrial capitalism), or that “fiat-money” is the cause-of-our-doom, (since there's nothing wrong with growing the monetary base in conjunction with the real economy, which is different from excessive credit). Such a talent for creating theatrical hysteria out of the epiphenomema of problems of underlying production is almost worthy of admiration. The idea that money ought to be a permanent store-of-value amounts to a metaphysical fantasy of eternal Being, whereas, in fact, all Being is temporal: there is a reason why it is called “currency”. In fact, money is only ever a semiotic instance, a representation of “value”, rather than the “thing” itself, and to imagine that gold or any other “hard” medium would not be so, is sheer fetishism. In fact, what qualifies a monetary medium is its uselessness, hollowness, its lack of substantial “value”, by which it can accrue “value” through exchange processes. And that there would be a “natural rate of interest” misses both that there is an on-going process of adjustments within the sphere of production, which doesn't depend on interest rates, but rather interlocking production constraints, and that long-run real capital investment doesn't depend on current interest rates, but on long-run returns through a variety of interest rate and business cycle environments, the returns on which, in turn, “pay” for interest rates. Neither a market-based “natural” interest rate, nor a manipulated one, suffice to fully resolve underlying problems of real productive capital investment, nor adequate distributions of returns to labor, (through the other interest rate channel of substituting debt-financed consumption for wage-based income). But most of all, the claim that our current woes are solely due to “fiat currency” strikes me as the height of fallacy. That the U.S., at the behest of its dominant oligopolistic interests, has been abusing its reserve currency status by running a dollar-kiting scheme, is not the fault of “fiat currencies”, but rather the fault of unchecked trade imbalances, which have been allowed, with symbiotic collusion with different interests of foreign developing countries, due to the influence of oligopolistic MNCs. That that might involve the interlinking feed-backs between much different economies with much different standards of “value” is not beside the point, but it's more the result of real flows than nominal currencies,- and, at least, implicit deals between dominant partners. To wish such factors away, as much as to imagine that “free markets” would render them impossible, is to invert hard realities into the haven of a peculiar ideological utopia, one which imagines it's tackling such realities, through its very “hardness”, by ignoring them.

Steve,

I know you like this idea of lots of small democratic investors using their individual knowledge and voting the price of individual stocks with weight based on the value of the shares they purchase, but this is a very dangerous idea. It's like saying let's have everyone in the U.S. vote on diagnosing that lump on your neck, rather than undemocratically having only a group of doctors do it who have studied such things intensely in school and on the job for decades, and have spent a lot of time carefully reviewing your x-rays and tests.

Laypeople have little or no training for pricing individual stocks, and it takes years of training not to make big and common mistakes, and they have very little time to study the companies. They have other jobs and that takes a huge amount of time to do well.

You really don't want huge numbers of uninformed laypeople spending substantial percentages of their money on single stocks. It's very dangerous for them, and it's going to make stock prices far less efficient, far less reflective of true values.

And it's not like the skilled investors at the margin will just bid the prices all the way back to their true values. They don't control a high enough percentage of national wealth, and there are a lot of other problems with that, well established in academic finance. One of the much lesser known, but very large ones, I pointed out in a 2006 letter in the journal Economists'Voice (by the way, edited by Brad DeLong and Joseph Stiglitz):

One reason which was missing, at least
explicitly, and which I have not seen yet in
the literature, at least explicitly, is that a smart
rational investor is limited in how much of a
mispriced stock he will purchase or sell by
how undiversified his portfolio will become.
For example, suppose IBM is currently
selling for $100, but its efficient, or rational
informed, price is $110. It must be remembered
that the rational informed price is what
the stock is worth to the investor when added
in the appropriate proportion to his properly
diversified portfolio of other assets. Such a
savvy investor will purchase more IBM as
it only costs $100, but as soon as he purchases
more IBM, IBM becomes worth less to
him per share, because it becomes increasingly
risky to put so much of his money in
the IBM basket. By the time this investor has
purchased enough IBM that it constitutes 20
percent of his portfolio, the stock may have
become so risky that it's worth less than $100
to him for an additional share.
At that point he may have only purchased
enough IBM stock to push the price
to $100.02, far short of its efficient market price of $110. Thus, if the rational and
informed investors do not hold or control
enough—a large enough proportion of the
wealth invested in the market—they may not
be able to come close to pushing prices to the
efficient level.

Lovely point about investing in the market rather than narrowly.

Let me put it another way; if you encourage laypeople to buy single stocks, what information are they adding? It's true that some laypeople may have a bit of good useful, unique, individual information here and there on a company, but on average it's going to be microscopic per person. And it's not just that microscopic bit of good information that will be imputed in the price, it's also bad information and bad analysis from the layperson that will be imputed in the price, that's gigantically larger.

The ratio of good signal to bad signal and random noise is minute. This is going to hurt the accuracy of stock pricing far more than it will help it, just like having laypeople vote on diagnosis and treatment of cancer, rather than trained doctors, who have spent a lot of time studying the patient's data, is going to increase the probability of serious illness or death -- greatly -- not decrease it.

This is not a situation like where you want the market of regular people to decide on what shoes are produced. That's a situation where regular people have tremendous data and expertise -- on what shoes are good for themselves. An individual is usually by far the best expert on what kinds of shoes he will enjoy the most. But he's very far from the best expert on what the worth-it price of a stock is for him. There are so many common mistakes that would be made en-mass among laypeople.

Most laypeople don't even understand that obvious information will be, by and large, usually already reflected in the price. I don't know how many times I've heard people say things like, "I think Wal-Mart is a good stock to buy because they're so well run.". It's like saying I think a Honda Accord is a good car to buy because it's so well made, without asking, yes it's well made, but is it for the price? Is it if it costs $50/share and it takes 3,000 shares to purchase the car? No, it's a horrible buy at that price. But even smart laypeople often don't know that concept for stocks. It's not that they aren't smart; it's just that they have no training and have never spent a lot of time thinking about it, and are already way to busy with other things to start.

Few other industries are allowed to create money, but that is what the credit industry was doing by lowering lending standards and lending more to raise prices all on the back of leverage. The resulting debt has to be covered or written off through income, default, and inflation which takes time. Liquidity preference is high until then, to cover future losses as well as avoid them.

I am not sure the tradeoff is diversification losing information as much as diversification to avoid the costs of acquiring information. The expense of acquiring and processing this information creates the concentration of advisors and means higher costs to avert it.

IDK the existing state of knowledge. Two things I can think of are you get diminshing marginal returns when credit is cheap as there is a time delay before new good business can submit a loan application and there is a time delay before you realize diminishing businesses are started to tank.
Also, cash is a prerequisite for credit. A company that falls through its capital requirements and credit reserve ratios will fall even faster. A company that has a rising market cap or revenue is given the opportunity to borrow more. This is done on the basis of rewarding profitable companies but ignores the fact that there is a difference between lending to the same/better business model and lending to a marginally crappier model.

"I am of the radical opinion that a great number of the rich don't even pay taxes ... their entire income is stolen funds. The government gets a cut of the stolen funds."


JIMB, that's the "Matthew Effect". As the "Queen of Mean"(Leona Helmsley) so eloquently stated :"We don't pay taxes. Only the little people pay taxes"

One additional point - I really dislike the term "malinvestment". It's one of those value-laden, deliberately vague terms that enables it users (primarily Austrians) to frame the argument according to their own definitions (and effectively bake the desired conclusion into the premises).

The only possible "neutral" definition of malinvestment is investment that ultimately does not yield a return in excess of its economic costs. However, all investment decisions are made in the context of an uncertain future where returns cannot be known ex ante. Whether an investment will be good or bad is unknowable in the present.

Austrians would like to define malinvestment as investment in areas that would not have taken place in the absence of central bank policies that lowered the interest rate below the natural rate. This seems to me to assume that returns are known ex ante. It also assumes the existence of a "natural rate of interest". The latter point was central to the debates between Sraffa and Hayek. Sraffa demonstrated such a concept to be logically impossible, and demolished Hayek so thoroughly that Hayek essentially stopped writing about economics altogether afterwards.

Actually, I should be clearer, it's not that laypeople who buy index funds don't pay anything for the research done by others. By buying at prices that are at least somewhat less than optimal, they provide profit opportunities for those that do good research. The more they buy, the more profit there is available to the researchers. The thing is, there are still economic externalities that aren't fully captured in this, and from that there is some free riding. The question is how much, how big. Big enough to be worth the costs of doing something about it?

Charles writes: "Finally, regarding the Sraffa/Hayek controversy, it all boils out to the Keynesian fallacy of money as a store of value"

Fallacy? It seems to me a self-evident truth. Money most certainly does serve the function of a store of value, as can be verified by simply observing human behavior. And as Keynes noted, during periods of economic uncertainty, people attempt to increase their precautionary balances of money, which has a marked impact on real economic activity.

Of course, in order for Austrian theory to "work", money MUST not be anything more than a medium of exchange. So the Austrians simply assume the conclusion they are trying to demonstrate.

"Hayek is right in pointing out that there is as many rates of interest that there are commodities."

Umm, that's what Sraffa pointed out, not Hayek. It renders the entire concept of a "natural rate of interest", and thus Austrian Business Cycle theory which depends upon it, incoherent.

BSG: Hayek published his last works on pure economics, The Pure Theory of Capital and Profits, Investment, and Interest in 1941. After that, he wrote about political philosophy, sociology, law, epistemology, and psychology. He may have touched upon economic topics in some of those later works, but he was no longer writing about economic theory.

I'm going to advance the notion that "functional" unemployment actual does rise dramatically during a boom.

During the present boom many people:
* Started loss making businesses with their own, or others, borrowed capital.
* Went freelance working 1-3 days a week in inflated sectors (I've heard of a firm pay $7000 per "email broadcast".)
* Became "professional" landlords.
* Cut their hours to pickup income support as unskilled salaries fell in real terms.

Those people were unemployed in a literal sense, as they'd voluntarily exited the job market. They just weren't looking for work, or claiming full benefits.

Then you add in the malemployed [those who work in industries that generate and/or consume "fake" credits]. (I'd list some examples, but it'd only degenerate to a list of people better paid than me who do something I don't understand...)

Perhaps this is the true breaking point - where the fruppochino drinkers fail to produce enough goods to motivate the fruppochino servers - rather than any specific debt or capital level :-)

This might help explain how the boom became so entrenched in the UK. We drew down Poland's supply of engineers, mathematicians and lawyers into our fruppochino serving classes, preventing the need to balance fruppochino consumption and barristas... until the £ dropped... now they're all going home!

Charles Monneron's comment is a truth that so many simply don't understand and most of those who do are still trying to deny- there are few "innocent" Americans that didn't profit from the boom in one form or another. The political calamity that is unfolding is a direct acknowledgement of this fact- almost everyone is due to lose some of this inflated wealth, but no one wants to. This applies to homeowners, stockowners, bondholders, government workers, service workers, manufacturing workers, etc. Almost everyone one of us profitted from the bubble and we are all cheerleading the politicians to protect our gains at the expense of everyone else. We are fools.

I think Steve Keen is right here - what is missing from PKs story is any concept of a balance sheet. Debt really is the problem, not "misallocation" of resources. (I'm not sure I really understand that argument anyway, why can't prices adjust in the meantime? For the debt story the problem is clear, people up to their eyeballs in debt aren't helped by a wage cut.)