Imagine having a fever so bad that it permanently raised your body temperature. Now imagine a period of unemployment so bad that it permanently reduces our economy’s ability to produce things and employ people. That’s hysteresis — the long-term scarring of our economy from periods of short-term unemployment. I’ve discussed this before, and I think the evidence is very convincing it is a major issue. Hysteresis is part of the engine in the recent Brad Delong/Larry Summers paper arguing for self-sustaining stimulus.
Crucially, hysteresis is an intellectual challenge to the so-called structuralists who would argue that we should ignore the short-term economy and just focus on the long-run health of the economy. Beyond us all being dead in the long run, the long run is just a series of short runs right after each other. And hysteresis shows that short-run problems can perpetuate themselves and become embedded in the long-run economy.
The fatal flaw in this analysis is that it presupposes that the future is knowable to a high degree of certainty and, more importantly, that the effect of theoretical tradeoffs are knowable and calculable. This is, of course, nothing more than the pretense of knowledge, writ large. There is no way to tell what an economy would “naturally” look like in the absence of a recession, nor is there any way of knowing whether a particular recession was avoidable or whether it would have been possible to reduce the severity of a given recession.
More specifically, it’s impossible to know what theoretical production looks like in the future in the absence or presence of given policies. Production may permanently decrease because, say, demand for the product may decrease. Or maybe the new regulation that pops up to deal with a recession increase marginal costs. Maybe there are structural problems. There’s simply no way to tell, and playing “what-if” games does nothing to identify the problem, let alone determine a possible solution.
In short, the hysterics over hysteresis are completely unnecessary, and are likely a by-product of a few theoreticians perceived self-importance. Thus, it’s easy to get worked up over potential problems when you think that a) you can accurately identify them and b) actually fix them. If this isn’t arrogance, I don’t know what is.
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University of California (Berkeley) economist Brad DeLong took my late-in-life education on economic issues to a new level. I’ve plenty more to learn, of course, but I enjoyed his discussion.
Here’s a snippet from his article in the Seeking Alpha web site:
In such a setup, the conclusion of Mankiw and Weinzerl that monetary policy has the exclusive role to play is straightforward: One stabilization policy tool–monetary policy–is non-distortionary. The other stabilization policy tool–fiscal policy–is distortionary. If monetary policy can do the job, there is then no need for fiscal policy. And if you do resort to fiscal policy, use the fiscal policy that is most effective at getting people to spend money on the things they were at the tipping point of buying anyway–use the investment tax credit rather than direct government purchases or tax cuts which might well not be spent. End of argument.
Well, actually it wasn’t the end of his argument. He goes on to assert that well-designed fiscal policy is as important and powerful as monetary policy during unusual times like we are experiencing right now.
Prof. DeLong’s discussion is a bit tough going for Principles students. Let me see if I can translate.
In normal times, when short term interest rates are noticeably above zero, monetary policy is often the best tool for government to use to correct the economy. In class we talk about correcting for either a recessionary gap or an inflationary gap. DeLong agrees with Mankiw and Weinzerl that monetary policy is sufficient and does less to distort the marketplace. What does he mean by distortion? In a perfect economic world individuals make decisions on whether to save or spend and if they spend, on what kind of things. When government decides to spend additional money (i.e. uses fiscal policy) then that means it must raise taxes to pay for that spending. Those taxes change, or distort the decisions that rational individuals would make. This moves us away from our theoretically perfect model of allocating resources.
Potential vs. Actual (Real) GDP
As a side note, much government spending is valued by the public and helps correct problems in the market or helps society meet other goals – such as caring for the disadvantaged. So spending and taxes aren’t necessarily bad for those kinds of goals, but spending to stimulate an economy does potentially distort how we would use our funds. In my classes I also point out that fiscal policy is usually a pretty blunt instrument, wielded by not very expert politicians. There are all sorts of time delays, political compromises, and imperfect implementation. So, monetary policy is often the best way to solve short term, mild-to-moderate problems in the economy.
Back to DeLong. He agrees with Mankiw and Weinzerl, but goes on to argue that monetary policy has a hard time working during a liquidity trap – when short term interest rates, and the interest rate target set by the Federal Reserve are so close to zero that pumping more money into the economy just gives it bloat, rather than relief. In these tough times, monetary policy can possibly work if the Fed promises to keep interest rates lower and inflation higher in the future. However, DeLong points out that future Fed committees are not bound by the promises of today’s leaders. If investors think there will be a change of heart, and interest rates will rise in order to force inflation lower, then those investors will delay their spending plans.
On the other hand DeLong argues that an aggressive fiscal policy – i.e. more spending now, backed by printing more money, can have a strong impact, and the government will be less likely to back down from its policies in the future.
DeLong also argues that monetary policy can introduce distortion – by changing the relative amount we invest in projects with short term benefits versus those with long term benefits.
Here’s the last summation:
It is important to get the overall level of production right–to match total spending to potential output. It is also presumably important to direct spending toward high-value commodities. It is important to get the balance between private and public purchases right. And it is important to get the balance between short-duration and long-duration assets right.
Thus fiscal and monetary policy are likely to both have proper stabilization policy roles to play.
Watching Europe sink into recession – and Greece plunge into the abyss – I found myself wondering what it would take to convince the chattering classes that austerity in the face of an already depressed economy is a terrible idea.
After all, all it took was the predictable and predicted failure of an inadequate stimulus plan to convince our political elite that stimulus never works, and that we should pivot immediately to austerity, never mind three generations’ worth of economic research telling us that this was exactly the wrong thing to do. Why isn’t the overwhelming, and much more decisive, failure of austerity in Europe producing a similar reaction?
Let’s lay out some definitions first: GDP, by definition, includes government spending; success, according to Keynesians, is some amount of economic growth (measured over arbitrary time periods and in the aggregate); austerity, by definition, will generally require cutting government spending. Now, Keynesians generally don’t care where increases in GDP come, so long as increases occur. Austerity, though, very much emphasizes balancing government budgets, which generally means cutting spending since it is rare for a government to a) be running only a minor deficit and b) raise tax rates enough to cover the current deficits. Thus, austerity usually requires a significant cut in government spending, and thus a cut in GDP (since government spending is a component of GDP). Thus, complaining that austerity doesn’t immediately lead to economic growth is like complaining that water is wet, in that we’re only really dealing with definitions.
Furthermore, austerity does not directly concern itself with growth. As was mentioned before, austerity is mostly about balancing a government’s budget (to put it crudely). Trying to evaluate austerity in Keynesian terms, then, is somewhat disingenuous as austerity does not have Keynesian goals, nor does it concern itself with the Keynesian analytical framework. Rather, austerity focuses on paying back government creditors, and that is thus the framework by which it should be analyzed. To use Keynesian metrics and goals to measure the success of austerity measures is akin to analyzing quarterbacks by their OBP. In both cases, the analytical framework simply is not suited for the thing being analyzed. Therefore, it is safe to say that only a fool, an ignoramus, or a liar would judge austerity by the economic growth it provides.
Was it Popeye’s friend, Wimpy, who kept asking for a hamburger on credit? Today’s credit markets are anything but robust, with reduced demand and supply for borrowed funds. Always eager to find obscure terms for modern dilemmas, economists refer to this condition as a liquidity trap. With a little prodding from Facebook friend and neighbor, Patrick, we’ll give the concept a once over.
Jumping to the conclusion (and resisting the academic approach of a slow, careful warm-up) there is bad news and good news about liquidity traps. The bad news is that they make it difficult for the Federal Reserve to execute monetary policy. Creating 100s of billions of dollars has a muted impact on our economic recovery. The good news is that the liquidity trap dampens the significant inflation we might expect with the creation of all that money.
OK, back to the beginning. During times of slow or no growth and high unemployment the Federal Reserve can create/inject money, largely by increasing reserves that banks have in their accounts with the Fed. They can do this by buying U.S. treasury bonds on the open market, or even by buying troubled/toxic assets from banks. This increase in the supply of money allows interest rates to fall, which in term spurs demand for more consumption and investment. This is classic monetary policy. With mild downturns this is often enough to increase growth and kick start the economy. For the most recent 2007-2009 recession the Fed took these actions, a number of times in a number of ways, and those actions were not sufficient. Now the target short term interest rate – the Fed Funds rate – is essentially at zero. The Fed can’t lower the interest rates any further. Here’s a graph of the Fed Funds rate since 1980. The big peak at the beginning of the graph was the result of aggressive Fed action to contain inflation. Now, though, the rate has sunk to the very floor.
Fed Funds Rate – St. Louis FRED database
One thing that is happening is that while reserves are building up in our financial system, the banks are holding on to them rather than increasing their lending. Some argue that the banks are using the added funds to improve their balance sheets, which were hurt by the dramatic loss in value of securitized mortgages and other derivative assets, and to build up enough cash to pay executive bonuses. The banks argue that demand for credit by qualified borrowers is low. I don’t put much credence in the latter explanation. One apt analogy for this situation is that the Fed is trying to push on the end of a string, in order to get the economy going.
There is another layer to the liquidity trap concept, and that has to do with the buying public’s (people and business) expectation for inflation. The theory goes that if buyers expect inflation in the future, they will increase buying now. They expect the value of their cash or savings to go down during inflationary times, so they seek to use it now, while its value is still high. This works with traditional monetary policy where an injection of money would be expected to increase inflationary pressures.
On the other hand if purchasers believe that inflation will be controlled, then there is less pressure to buy now. That’s what is happening now. Despite what some politicians suggest, inflation is not right around the corner, and buyers are in no hurry to convert their cash into goods. We see evidence of this with the continuing low interest rates on U.S. bonds. Expectations of high inflation would push those interest rates up. Low inflation expectations, even in the face of increasing money supply is another symptom of a liquidity trap.
This scenario played out, to grim effect, in Japan in the 1990s, as their central bank poured money into the banking system and no one responded. Their “lost decade” was one of almost zero growth.
This paper by a New York Federal Reserve staff economist explains things in more detail, complete with impenetrable equations.
Freidrich Hayek and the Austrian school of economic policy argue for a laissez faire approach to the economy – emphasizing individual actions and criticizing government intervention. John Maynard Keynes acknowledged that economies could, over time, correct themselves, but argued that government had a responsibility to intervene and stimulate demand when the economy is in a slump. This video is a sequel to Fear the Boom and Bust, also produced by Econstories.tv
For my students, see how many of today’s economic issues you can find in this video and compare them to our look at the Great Depression.
Late last month, President Barack Obama signed legislation that will cut taxes and provide credit help for small businesses. It is yet another step that the government is taking to continue programs that spur job growth in the U.S. economy.
The Small Business Jobs Act is now the fourth jobs measure that Congress has enacted this year — it is likely to be the last before the Nov. 2 midterm congressional elections.
The bill provides billions of dollars worth of tax cuts over the next 12 months, with the bulk coming through “bonus depreciation.” The measure allows companies to more quickly write off the cost of business-related purchases. The bill also revives stimulus provisions that cut fees and increase limits on loan guarantees offered by the government’s Small Business Administration.
Continuing the theme of my recent posts. This from Troy Schwensen at The Global Speculator:
Australia’s Prime Minister, Kevin Rudd, has recently delivered an address to the nation providing details on his second stimulus package. Within this briefing, there was a number of sniping remarks about the so called “failure of free markets”. This apparent failure has forced the government to step in and clean up the mess. … It seems free markets cannot be trusted to spend money wisely, so it is up to the government to spend our money for us. I want to make a couple of points.
Firstly, free markets work fine. The global problems we have experienced in the credit markets were caused by easy monetary policy. Many argue the cause was a lack of financial sector regulation. The more pertinent question to ask is why does the financial sector need so much regulation in the first place? Why is it that free markets work well in other industries but fail so dismally when it comes to the financial sector? The answer is quite simple. The financial markets are anything but free! We have a government entity called a central bank that essentially sets the price of money. It decides the level of interest rates under the flawed belief that the market is incapable of performing this function on its own. …
The second point I want to make is governments are incapable of investing money smarter than individuals and companies. By deficit spending, they are drawing funds away from the capital markets and effectively competing with businesses for money. Over the longer term, this will put upward pressure on interest rates exacerbating our economic problems. What Australians should be doing right now is saving and paying down debt. At some point this will inevitably have to happen anyway. By lowering interest rates to historically low levels, the message central banks are sending is don’t save, borrow and spend. Governments are releasing stimulus packages encouraging us to spend and “save the economy”. You cannot save an economy via consumption. All you are doing is prolonging the agony. Individuals and organizations need to clean up their balance sheets and save.
The G-8 is composed of the U.S., Japan, Germany, France, U.K., Canada, Italy and Russia. Representatives met over the weekend in Lecce, Italy to begin crafting an agenda for when a broader set of leaders meet on July 8-10.
The group acknowledged that they are now considering how to back out the swift rescue actions taken last year because the world economies are beginning to show signs of recovery.
“We discussed the need to prepare appropriate strategies for unwinding the extraordinary policy measures taken to respond to the crisis once the recovery is assured,” the leaders asserted in a collaborative statement. “There are signs of stabilization.”
“Early signs of improvement are encouraging, but the global economy is still operating well below potential and we still face acute challenges.” said U.S. Treasury Secretary Timothy Geithner.
“There is a distinct shift in tone from the G-8″ during this meeting, said Eswar Prasad, of the Brookings Institute.
“There are increased signs of stabilization in our economies,” the G-8 re-emphasized. The group renewed their commitments to take “all necessary steps to put the global economy on a strong, stable and sustainable growth path.”
C.S. Lewis’ short but masterful The Great Divorce is about Ghosts in Hell who journey by omnibus up through a crack in the earth to meet Solid People and hopefully be guided into the mountains. As the Ghosts become substantive their feet are pricked by the sharp grass. Only a few overcome their problems and journey into the mountains while most board the bus and shrink into oblivion as it descends back down the crack from whence it came.
In the financial realm, many are lured by the the derivative illusion and ensconced in a rapidly dissipating cocoon of self-satisfied self-deception woven over their eyes and mind leading to their faulty thinking that the way they see things is the way things really are. Fractional reserve banks and fiat currency have wrecked predictible havoc and mayhem on the entire world economy. Fortunately, monetary and currency alternatives exist.
HOW TO INTENTIONALLY CAUSE THE GREATER DEPRESSION
The Great Credit Contraction and the accompanying liquidation of malinvestment is to be embraced and not feared. As Murray Rothbard observed on page 18 of his 1963 America’s Great Depression, “It is true that credit contraction may overcompensate, and, while contraction proceeds, it may cause interest rates to be higher than free-market levels, and investment lower than in the free market. But since contraction causes no positive malinvestments, it will not lead to any painful period of depression and adjustment.”
Mr. Rothbard continues the observation that government policy can hobble the adjustment process by: “(1) Prevent or delay liquidation, (2) Inflate further, (3) Keep wage rates up, (4) Keep prices up, (5) Stimulate consumption and discourage saving and (6) Subsidize unemployment.”
In the present case, mark-to-market rules, like FAS 157, are not implemented, delayed, ignored or willfully violated. For example, Section 132 of the Emergency Economic Stabilization Act of 2008 is titled “Authority to Suspend Mark-To-Market Accounting” and restates the SEC’s authority to suspend the application of FAS 157.
The Austrian definition of inflation is an increase in the money supply. The Adjusted Monetary Base, the very lowest layer of power money, shows a tremendous increase over the past couple months. The effects are most likely masked by the tremendous slowing in the velocity of money.
In an effort to stimulate consumption and discourage savings that will result in keeping prices and wages high the Obama administration has unveiled a $1 trillion stimulus package. The Geithner toxic asset plan will only serve to hasten the destruction of wealth from the economy as the system evaporates.
Minimum wage is set to rise for the third consecutive July. Unemployment will be subsidized by extending benefits for 13 weeks and delaying the income tax payments. Legacy industries, like the auto industry, are receiving bailout money to keep wage rates up and people employed doing nothing all day long because of the huge over capacity of automobiles.
Austan Goolsbee, a senior Obama economic adviser, said on CBS’ Meet the Press, “We’re out with the dithering, we’re in with a bang.”
FINANCIAL INSANITY VIRUS EPIDEMIC OUT OF CONTROL
Well, it is obvious that the Financial Insanity Virus epidemic is raging on Wall Street and in Washington. They are hitting the bulls-eyes on all six policies to hobble any potential recovery. The result will be a lengthening and intensifying of The Great Credit Contraction and resulting Greater Depression. Worse is that these criminal gangs costumed in government regalia have no excuse for not knowing what the result will be. Therefore, they are acting either with premeditation and deliberation or with reckless disregard for the world economy and all the individuals affected.
This will result in a lot of economic and physical pain and misery coupled with individual culpability. As the mentor in The Great Divorce sagely taught, “All who are in Hell choose it. Without that self choice there could be no Hell.” Indeed, “to be afraid of oneself is the last horror.”
“All Hell is smaller than one pebble of your earthly world: but it is smaller than one atom of this world, the Real World.” The Great Credit Contraction continues to grind while the illusions evaporate making many organizations and institutions increasingly irrelevant. Hopefully these soon to be worthless entities that are gluttonous parasites on the global economy will become at the most footnotes in the annals of history.
“The Audacity of Hope” is a catchy phrase with important implications. It is good to hope, to look forward boldly in anticipation of better times, to have a positive outlook that is open to opportunity. But, just as it is not a good idea to run around in the dark with a sharp butcher knife, it is also not a good idea to boldly pursue policies with blinders on, while wielding dangerous economic weapons.
The “war on poverty” has been a miserable failure, in spite of the trillions of taxpayer dollars spent over the last 4 decades. The “war on drugs” is another expensive failure on all fronts. Central planning in American education has resulted in a very expensive system that is failing our children. Ask any supporter of the welfare state, however, and the ongoing failures of government programs result only from not throwing enough money at them. It doesn’t matter what miserable results from whichever government program, the only proposed solution to the problems is more money stolen from taxpayers.
In the real world, if a private business or association is not successful, it either changes the way it does business and serves people or it takes a one way trip to the business graveyard. Bankruptcy and failure ensure that bad ideas or inefficient, unproductive systems don’t keep sapping life from the productive sectors of society. That is the way that society progresses and economies advance.
Not so with government. It seems that the bigger the failure, the more support it gets. We have been victims of expensive stimulus plans for some time now. Remember the cure-all about a year ago? If only the wise politicians could take enough money from taxpayers to redistribute to taxpayers, they could jump-start the economy. Not enough. More billions prop up banks and failing businesses. Between the Federal Reserve Bank, FDIC and the multiple stimulus spending plans, the toll is now in the multiple trillions of dollars.
With all of the smart people purportedly hanging out in Washington DC, you would think that they might realize that, if you take a dollar from Joe and give it to Frank, and a dollar from Frank and give it to Joe, you really haven’t stimulated either. Worse yet, if you take a two dollars from Frank, give one to Joe and keep one to feed the beast, you have actually de-stimulated and made the whole economy less productive.
Stimulation is the fundamental reason that this country and the world are in their present sad state of affairs. Central banks try to stimulate economic performance at the beginning of an economic boom by pumping counterfeit money into the economy and lowering interest rates below the market rates. That stimulation only distorts the real economic incentives. The inflation devalues the dollar and creates bubble economies, where certain sectors inflate at a quick pace, giving the illusion of rapid real growth. In the present case, artificially low interest, specific homeowner incentives, government subsidized mortgages and ownership programs, and requirements for banks to offer loans to risky borrowers combined for the deadly combination that exploded into the current meltdown.
Those same smart people in our nation’s capital choose to ignore the obvious, and instead, throw trillions of dollars of good money after bad. Instead of fixing the core problem, they play political games for fun and profit. It is hard to believe that hundreds of the most well connected and powerful people in the country can be so willfully ignorant. That is, hopefully, the case, however, because if it isn’t, it means that, instead, they are willfully malicious. They consciously hurt the people they pretend to help.
Audacity, in the positive sense, means boldness or daring. It is a characteristic of effective leaders.
There is, on the other hand, an old saw among seasoned airplane pilots: “There are old pilots and there are bold pilots, but there are no old bold pilots.” Audacity is sometimes the precursor to disaster, because it substitutes cockiness for clear thinking, and throws caution to the wind. In this time of crisis, our leaders have thrown caution to the wind. They are flailing in the dark so they can say they are doing something. They are prescribing poison as the antidote for poison. They don’t think about the ramifications and, instead, rely on knee jerk reactions, which will ultimately multiply the problems they themselves have created.
Wouldn’t it be refreshing if our politicians would have the audacity to actually think for a change?