Preventing 2006
Brad DeLong periodically reproduces the following bit from Keynes:
While some part of the investment which was going on in the world at large was doubtless ill judged and unfruitful, there can, I think, be no doubt that the world was enormously enriched by the constructions of the quinquennium from 1925 to 1929; its wealth increased in these five years by as much as in any other ten or twenty years of its history….
Doubtless, as was inevitable in a period of such rapid changes, the rate of growth of some individual commodities could not always be in just the appropriate relation to that of others. But, on the whole, I see little sign of any serious want of balance such as is alleged by some authorities. The rates of growth [of different sectors]… seem to me, looking back, to have been in as good a balance as one could have expected them to be. A few more quinquennia of equal activity might, indeed, have brought us near to the economic Eldorado where all our reasonable economic needs would be satisfied….
It seems an extraordinary imbecility that this wonderful outburst of productive energy [over 1924–29] should be the prelude to impoverishment and depression. Some austere and puritanical souls regard it both as an inevitable and a desirable nemesis on so much overexpansion, as they call it; a nemesis on man’s speculative spirit. It would, they feel, be a victory for the mammon of unrighteousness if so much prosperity was not subsequently balanced by universal bankruptcy. We need, they say, what they politely call a ‘prolonged liquidation’ to put us right. The liquidation, they tell us, is not yet complete. But in time it will be. And when sufficient time has elapsed for the completion of the liquidation, all will be well with us again.
I do not take this view. I find the explanantion of the current business losses, of the reduction in output, and of the unemployment which necessarily ensues on this not in the high level of investment which was proceeding up to the spring of 1929, but in the subsequent cessation of this investment. I see no hope of a recovery except in a revival of the high level of investment. And I do not understand how universal bankruptcy can do any good or bring us nearer to prosperity…
I won’t comment on the “wonderful outburst of productive energy” Keynes attributed to the late 1920s. But I do have an opinions about the quinquennium from 2004 to 2008.
It was stupid. We were profoundly stupid. We mismanaged resources catastrophically, idiotically. We substantially oriented our economy around residential and retail development that was foreseeably excessive and poorly conceived. We encouraged ordinary consumers, rather than entrepreneurs, to take on debt, and let the credit thus created serve as the kitty in a gigantic casino of egoism. We saw the best minds of a generation destroyed by madness, glutted hysterical in suits, dragging themselves through the Street at dawn, looking for an angry bonus. We accelerated the unraveling of physical, social, and intellectual infrastructure that took a century to build and that we will desperately need some day, perhaps quite soon. We celebrated our stupidity. Based on some back-of-the-napkin theorizing, we turned virtues like planning and prudence into cost centers, and eliminated them. We idolized “the market” while at the same time reorganizing it so it would tell us exactly what some privileged groups found convenient to hear.
I am sure someone will shout “20/20 hindsight”. That’s bullshit. Everything I am saying now was obvious five years ago, and lots of smart people knew and understood it. Some of us even bought into “arbitrage” fairy tales and tried to profit from getting our views “impounded into market prices”. We learned to take a different Keynes quote seriously, the one about markets remaining irrational longer than you can remain solvent. [Shlieffer and Vishny’s famous coinage, “the limits of arbitrage” is not strong enough, because it suggests that efficient arbitrage is the norm subject to some exceptions and limitations. It is more accurate to view efficient arbitrage as the unusual special case, in bond markets as well as in equity markets.]
John Hussman, in an excellent weekly note, has a very mean quote:
The true debate in economics is…between economists who care about the productivity of resource allocation and those who only pay lip service.
That is harsh, but not wrong. I’d draw the lines a bit more mildly, and say that the core argument is between people who think we are in a financial crisis that has engendered an economic crisis, and others (like me) who think that the financial crisis is the outgrowth of longstanding and continuing economic mistakes.
Don’t worry. Even if you think the economic problems preceded the financial crisis, you still get to be mad at bankers. I feel about the financial sector the same way I would feel about my morphine dealer after looking down to find piranha feeding between my ribs. It’s worse than that. It’s like you pay some guy to find the best swimming holes in the Amazon and not only is he clueless, but he anesthetizes you so you don’t notice when he screws up and he eventually starts taking kickbacks from the fish. The financial sector failed three times. First it screwed up real capital allocation, throwing money at housing and consumer lending rather than finding and funding projects that would situate us well going forward. Then it failed again by seeming to succeed, when a good financial system would quickly render poor investment decisions unmistakably noxious. It’s best not to find yourself swimming among piranha in the first place, but if it happens, you want the very first nibble to hurt like hell. Finally, the financial sector failed by keeping itself rich and its creditors whole, which, despite protestations to the contrary, amounts to a failure at an institutional level to understand how badly it fucked up and make corrections going forward.
If “malinvestment” (and related maldistribution) is at the root of our problems, does it follow that austerity is the solution going forward? Not at all. Past poor investment is a sunk cost, our task now is to maximize the usefulness of resources that we still have. Failing to use perishable resources, especially resources that decay with disuse, is terribly dumb. “Stimulus” and “austerity” are both simpleminded and poorly specified strategies. In theory, we have two overlapping systems, a financial system and a political system, whose shared purpose is to make information-dense decisions about how best to use or conserve our resources. It’s not clear how we should make these decisions when both systems seem badly broken. But you go to the future with the institutions you have, not the institutions you might want or wish to have at a later time.
As we evaluate financial reform and political change, we should keep in mind that it is not 2008 that we must struggle to prevent. It’s 2006 that was the worst of times, the piranha were feeding while we splashed and giggled in our water wings.
Some notes: If you didn’t catch the references, I’ve mutilated quotes from the Alan Ginsberg poem Howl and from former US Defense Secretary Donald Rumsfeld in the text, and sourced them only via links. Regarding my own experience trying to help “arbitrage away” the credit bubble, I was short US equities from around 2005 until late 2008. The market was irrational until I was almost, but not quite, insolvent. Eventually I took a decent profit, but it was sheer luck that the market didn’t remain irrational just a bit longer and force me from my positions at a terrible loss.
- 13-July-2010, 7:40 a.m. EDT: Added missing “what” as in “exactly what some privileged groups found convenient to hear”.
[…] To solve our economic problems we need to prevent 2006, not 2008. (Interfluidity) […]
July 11th, 2010 at 6:29 am PDT
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In order to retain logical coherence, the simple Keynesian or Monetarist argument requires that the boom preceding the bust is not seen as a period of malinvestment or a bubble – If the seeds of the crisis were sown during the bubble, then just any easy money or fiscal spending program will not do. We need to make sure that our interventions during the crisis do not artificially support the structure of malinvestments made during the boom. We also need to make sure that our interventions do not make a future, more serious crisis even more likely (this is the essence of the “adaptive” systems approach I keep writing about – any commitment to stabilise the system against tail risks via monetary or fiscal policy is ultimately untenable as the system and its actors adapt to incorporate the knowledge of this commitment from the government).
Simple Keynesian and monetarist arguments ignore both points above. The Austrian approach is the only one that acknowledges the microeconomic allocational implications of macroeconomic policies. But most of them go too far by insisting on a blanket “let it burn” approach. My preferred approach would have been to let the bad actors, especially the banks go bust and focus govt expenditure on mitigating the fallout from this on the common man. Instead we’re doing just the opposite – bail out the banks, stop unemployment benefits. Hussman’s letter has a great quote: “The only difference between Keynes and Tim Geithner is evidently that Geithner prefers to place the bottles a bit closer to Wall Street.” I think that’s exactly correct and a pretty damning indictment of our priorities.
July 11th, 2010 at 8:44 am PDT
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People who made extremely bad decisions are protected. People who made bad decisions with other people’s money are rewarded. The crisis, therefore, will continue.
On the one hand, the volume of money does need to be managed so the price level remains approximately constant, so that money can operate a store of value and as a measure of value, and in this sense Keynesianism and monetarism are both true. On the other hand, the market has to be allowed to punish folly and reward ability – and in this sense, Keynesianism as actually applied in practice is badly wrong, and indeed catastrophically evil. We do need to let it burn.
July 11th, 2010 at 9:06 pm PDT
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Keynesian stimulus — *that* part of Keynesianism — is just dandy when used in a recession to compensate for insufficient natural demand, and overcome underutilization.
Let them burn when it won’t burn all the rest of us. Stress-test ’em (for real) in the good times, not the bad.
Government spends more/taxes less in the bad times, spends less/taxes more in the good times. As my 17-year-old would say, “No duh.” This is not rocket science (except politically).
Problem is that after 35 years of responsible government post-WWII (mostly under “profligate” Dems, you’ll notice), since 1981 we have been on a non-stop binge of out-of-control Keynesian stimulus, in good times and bad (except briefly, under Clinton).
http://www.usgovernmentrevenue.com/downchart_gr.php?year=1940_2015&view=1&expand=&units=p&fy=fy11&chart=H0-fed&bar=0&stack=1&size=l&title=&state=US&color=c&local=s
Driven by the very people who vilify Keynesian stimulus, and fight tooth and nail against it when it actually *is* needed and effective.
The supposed “decades of secular economic growth” post-Reagan that right-siders love to proclaim was built almost entirely on that phony platform of non-stop gusher stimulus. And since it was phony, a lot of the investment and growth that it stimulated and incentivized was also phony. Not just malinvestment (though plenty of that). Systematic malfeasance, starting at the top and — sure enough — trickling down.
It’s the curse of The Reaganomics Strategy:
Borrow from our children and from abroad, and use the money to buy votes here with the world’s oldest political pander: “I’ll cut your taxes!”
It’s been *spectacularly* successful for three decades. And it’s (at least in?)directly responsible for the troubles we find ourselves in today.
We’re trying to claw our way out of a three-decade hole dug systematically by Republicans, all the while claiming “fiscal responsibility.” Not really surprising that Obama hasn’t filled the hole yet after, what…a year and a half in office?
When Cheney said “Reagan proved that deficits don’t matter,” he was making a political, not an economic statement. People love to self-righteously bemoan deficits, but they vote for people who promise to cut their taxes.
The Republicans know that. Makes you wonder how Democrats manage to get elected ever, at all. They and their policies must be pretty damned popular.
Sorry to wander partially off topic…
July 11th, 2010 at 10:04 pm PDT
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[…] interfluidity » Preventing 2006 […]
July 12th, 2010 at 12:21 am PDT
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While Rumsfeld could only go to war with the army he had, he didn’t have to go to war to begin with. By contrast, like it or not, we’re going to the future with the thoroughly corrupted institutions we have. That’s why it seems like such a bleak future indeed.
A crucial and fascinating question is whether enough people will awaken from the apparent stupor to impose change before an outright collapse. Two related questions: Is there a point of no return along the way? Is our political system sufficiently resistant to electorally induced change so as to render a mass awakening all but moot.
July 12th, 2010 at 6:41 am PDT
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I think we were stupid, some profoundly so, but when we look back in ten or twenty years we will see we have actually produced considerable wealth and despite the craziness, very little will turn out to have been wasted. The reason I say this is because our craziness kept interest rates at what in retrospect will be found to be ridiculously high levels and when they have finished adjusting, it will be found that most will have been profoundly worthwhile.
July 12th, 2010 at 2:00 pm PDT
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[…] keep in mind that it is not 2008 that we must struggle to prevent,” Steve Randy Waldman writes at Interfluidity. “It’s 2006 that was the worst of times, the piranha were feeding while we […]
July 12th, 2010 at 4:27 pm PDT
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July 12th, 2010 at 9:30 pm PDT
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“As we evaluate financial reform and political change, we should keep in mind that it is not 2008 that we must struggle to prevent. It’s 2006 that was the worst of times.”
Precisely correct. But as for Keynes’ era, it’s nice to take a look at the parts of this list that occurred during his early lifetime. Keynes was born in 1883, was 17 at the turn of the century, and in his late 40’s / early 50’s in the Great Depression.
It’s hard to compare distant technologically-changing eras. How much things have changed in my lifetime, what with these internets, and myriad electronical devices? A lot, no doubt. But I think it’s safe to say that from the 1880’s to 1930’s, a typical life in the US or UK was virtually transformed by a burst of rapid and unprecedented technological (and intellectual) innovation – a trend which continued apace even during times of depression and world war. What quinquenniums were those which drove their booms and busts.
Our innovation boom was of a different character, it seems. The cleverest way to debt-finance consumption ever devised by mankind. Until it all came down.
At least we still have all those very nice houses into which we misallocated much of our resources. The fact that improvement to real property are by nature durable may be a saving grace of this debacle. Whatever happens to our economy or our institutions, for the next few decades, the population of humans who inhabit the geography over which we are presently sovereign will get to live in quality, spacious, and well-outfitted structures of a kind – it was scarcely dreamed by those a few generations past – would ever be available for men of ordinary means.
But, if by some miracle he was left mostly untouched by the crisis, Mr Lucky Thrifty can buy his own sprawl-city McMansion with granite countertops at a foreclosure auction on the courthouse steps for a reasonable multiple of his income – and his mortgage will be guaranteed against default through the generosity of the government, and his rates will be at all-time lows.
And he too can dream the American dream. He’ll be one of the few level-headed working-men, burning for the ancient heavenly connection to the greenback dynamo in the machinery of America.
July 12th, 2010 at 9:49 pm PDT
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[…] Steve Randy Waldman at Interfluidity: I feel about the financial sector the same way I would feel about my morphine dealer after looking […]
July 13th, 2010 at 12:08 am PDT
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[…] Preventing 2006 Steve Waldman. I’m late to this very good post. […]
July 13th, 2010 at 5:43 am PDT
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Problem is that after 35 years of responsible government post-WWII (mostly under “profligate” Dems, you’ll notice)
It’s not worth reading the rest of your post if you honestly believe that LBJ’s guns and butters were “responsible government”.
July 13th, 2010 at 9:03 am PDT
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I like the commenter who considers Keynesianism — if only Obama had tried it! — to be “catastrophically evil.”
Nothing like focusing attention away from the banksters who actually had the power and made the decisions. They’re the catastrophically evil ones.
July 13th, 2010 at 9:22 am PDT
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[…] ‘The financial sector failed three times. First it screwed up real capital allocation, throw…‘ (h/t Naked Capitalism) […]
July 13th, 2010 at 11:10 am PDT
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“We saw the best minds of a generation destroyed by madness, glutted hysterical in suits, dragging themselves through the Street at dawn, looking for an angry bonus.”
Actually we destroyed engineering as a profession and the smart kids saw the writing on the wall and went into finance.
July 13th, 2010 at 5:06 pm PDT
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[…] Intefluidity: Preventing 2006 […]
July 13th, 2010 at 7:34 pm PDT
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Please give me a break on blaming the financial sector. Yes they were a part of this, but the driving force was the liberal policies from the Democrat party pushed by Barney Frank, Chris Dodd et. al. This is unarguable as it has been on tape on Youtube for years. The Republicans fought against it and were demagoged as usual. Well that works for the elites on the east and west coasts. It has brought everyone else a depression. And yes we are in a depression as defined by economics as a drop of 10% or more in GDP. The only reason it doen’t show is that the liberals and led by Obama have spent more than that from the government treasury.
July 13th, 2010 at 11:39 pm PDT
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[…] The political economy of the subprime mortgage credit expansion – To paraphrase the Kissinger’s quote: “My knowledge of economics/finance is one of the reasons to oppose politics.” You should also read this. […]
July 14th, 2010 at 7:16 pm PDT
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[…] interfluidity » Preventing 2006 This is worth reading on our profound stupidity in 2004-2008 (from @interfluidity) […]
July 17th, 2010 at 12:43 pm PDT
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If “malinvestment” (and related maldistribution) is at the root of our problems, does it follow that austerity is the solution going forward? Not at all. Past poor investment is a sunk cost, our task now is to maximize the usefulness of resources that we still have.
Clearly encouraging more malinvestment and having central planners come up with ways to redistribute resources already invested is not a solution. If we let the market do its job we do not waste the resources sunk into bad investments but provide a liquidation mechanism that ensures that they get into the hands of those who are best able to utilize them. To argue that it is better to allow bad investments to stay in the hands of the people who made them makes no sense.
Let the lousy investors and managers fail and allow the resources to go to those that deserve them more.
July 20th, 2010 at 1:39 pm PDT
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Since the crisis began in 2007, the fair comparison for 1925:1929 would be 2003:2007. I don’t think that period was net stupid at all. There was a lot of gross stupidity, perhaps even more than usual (which is pretty high bar). But if you think it wasn’t an era of progress, then…pehraps you could use some of my old ethernet cables. US manufacturing productivity rose by almost 19% over those years. Aggregate nonfinancial business productivity (which includes construction, but that’s not what’s driving it) rose by 13%. And for a few years, most of the population participated in this growth. If there was “malinvestment”, there was a hell of a lot of “boninvestment” (?) too.
I will agree with you, though, that the underlying problems predate the crisis. And I think you may agree with me that the US balance of payments is heavily involved in those underlying problems. I see the current account deficit as a symptom, though, where the problem is the global savings glut. The US boom was a temporary solution to that problem. (As temporary solutions go, I don’t think it was quite as much of disaster as you and everyone else seem to think. By definition of “temporary”, such solutions always eventually fail.)
A permanent solution would involve something that either reduces the global propensity to save or makes it more profitable (in nominal terms) to invest those savings in productive activities (instead of holding them as money and bonds or playing games with them and investing them in nonsense like unnecessary housing). The latter could take the form either of an acceleration of inflation or productivity or of a substantial decline in real wages. (I can see the problem, though, with declining real wages or accelerating productivity: they will tend to increase the average propensity to save, since profits are more likely to be saved than wages, so on net, they may do more harm than good, so maybe the only solutions are reduced saving or inflation.) None of these things appears to be on the immediate horizon — but perhaps we can hope that the expected increase in dependency ratios in developed countries will eventually solve the problem of excess saving.
July 21st, 2010 at 11:07 am PDT
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@ Andy Harless
How can you mention the term ‘global savings glut’ while acknowledging that there was a decline in real wages at the same time? To me at least it’s blatantly obvious that those who should have been saving could not, whereas those who should have been investing much rather played games with their exploding profits. Global savings glut is a cynical misrepresentation of the horrific shift of net financial wealth from labour to capital between 1980 and today.
July 22nd, 2010 at 9:04 am PDT
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