Where I Take On a Nobel Prize Winner

I want to talk about the proposed auto bailout again in a macro context. As I concluded in my previous post, I am very hesitant to support the bailout because of the huge decrease in demand for cars, something that was started before the last few months and that initial evidence suggests will continue regardless of credit conditions. I believe that the credit crunch is merely the first symptom of underlying economic woes, not the driving force, and at some point will get around to putting together a bunch of charts that support this view. If demand does not increase and the car companies continue to bleed money then most of the arguments for the bailout don’t apply as the government will have to give them more and more money. At that point it would have been better off to let them fail and directly support the laid off workers.

However, this post isn’t about demand for cars per se, but the idea that we are just at the beginning of massive demand destruction across all industries; except perhaps entertainment and booze, which as the Great Depression showed are somewhat immune. This demand drop off will create an environment where government intervention beyond generalized bailouts will be called for. Indeed, some prominent economists are calling for this already. I’m going to talk about why I think they are wrong. Then I’m going to point out that letting things fall apart could actually be beneficial to long term goals.

The general idea is that there is a “natural” potential level for demand and employment, and that the business cycle overshoots this level both to the upside and downside. When the economy is doing very well then people make more and more goods until there is a glut, and then a recession starts, people are fired and demand drops. Theoretically, the government should let the supply glut work its way out of the system, but if demand falls too much and too many people lose their jobs, then we get into a positive feedback loop that makes things worse and worse and pulls us far away from the “natural equilibrium” point.

This is precisely the point that Paul Krugman has recently brought up time and again. Here he talks about how much direct stimulus would be required in order to close the current “output gap.” Many economists were against the tax rebate stimulus because they pointed out that people were in so much debt that it was unlikely to work. Those economists have been proven largely correct (I’ve read between 60-75% of it was saved either directly or paying down existing debt, in either case keeping consumption trends the same) and why the new ideas for stimulus are increasing unemployment or increasing direct government demand. Here Krugman explicitly addresses this viewpoint by saying that the government should attempt to stimulate the economy even if it has to do it by force and “recklessly.”

People that recognize macroeconomic policy even rudimentarily will know that this is the Keynesian approach to dealing with downturns. I do not believe that this approach will work, and in fact will make things much worse. I don’t want to argue that Keynes was wrong in general (as I don’t think he was) but at this particular moment in time his policies would fail. It seems that few economists are even thinking about macroeconomic and environmental changes that would make their equations invalid, and merely do what Krugman did where he suggested policy based on simple arithmetic and faith in a model.

In a more philosophical post I compared modern liberal economic thought (both Keynesian and monetarism) with the blind men and the elephant, who supposedly master their description of an individual piece without accounting for the whole. I’m not the only one that feels this way, a lot of scientists feel that economics should not consider itself a scientific discipline because there are too many confounding variables and it is not repeatable under observation.

I believe that the prominent economists and many liberals are forgetting some very important and obvious differences between today and the past. The first one is that we are already immensely in debt. I talked about this at length in my long series about why we are in trouble. The whole concept of Keynes is that done properly, we should save for rainy days by running surpluses in good times, and then spend those surpluses in the bad times. Obviously we forgot the “saving” part.

Because we are already in so much debt, adding to it will merely make interest yields rise enormously. I will demonstrate this through a very conservative calculation. Currently our foreign national debt is around 5.5-6 trillion dollars (the 10.5 trillion number is including domestic promises). This is about 40% of our GDP, and if you include private debt to foreign entities it would be significantly larger. Assuming an interest rate of around 4%, this means that about 1.6% of our growth every year is spent just paying back interest to foreign entities. If we add another $1-$2 trillion, which has been called for under stimulus plans, then it will rise to about 60% of GDP. Now 2.4% of our growth would be spent just paying back interest, and that number for an economy our large is very hard to maintain (advanced economies have a median rate of around 2%).

This means that unless something was done, we would get progressively poorer. The actual numbers are far worse as I didn’t include private debt, underfunded domestic commitments, increases in wealth disparity or foreign outflows, but I don’t want to exaggerate and those rates are beyond a simple calculation. The outcome is clear, we would either have to have a miraculous expansion of productivity, accept continuous and dramatic decreases in lifestyle, default on our promise to pay or inflate the monetary base. The credit market naturally assumes the latter two (for large nations inflation is most likely) and so demand for credit falls and interest rates rise. As this post points out, even natural laws of supply and demand will make interest rates rise tremendously aside from default or inflation concerns. This is one reason why Japan is floating the idea of bonds denominated in yen; then a devaluing of our currency would not affect their returns.

As interest rates rise, it just makes the problem even worse. If our interest rate rose to an average of 5%, then even our current amount of debt would barely be serviceable. What would happen is that increased interest rates would drive demand down even further and erode investment opportunities for people that had made wise decisions (by forcing them to invent their cash immediately and cash performance as opposed to safe and targeted investments), while we’d still be stuck where we are now. In essence, the stimulus would actually have a good chance of depressing demand even further.

On a more abstract level I challenge the validity of most of the models that economists use. It’s not that I think they are constructed improperly, it is that I don’t believe they are really universal. Too often it seems like economists use their equations like physicists use theirs, as though economics touched on fundamental truths – as if the equations were Laws, not Models! I think it is obvious that the environment that the models are constructed in matters greatly. For instance, a lot of modern economic thought has been derived during a period where we transferred to and then prospered under a petroleum based and mechanized economy. The period has also seen a huge population boom, quadrupling in the past 100 years. It is undeniable that any economic model implicitly relies on availability of resources, labor and efficiency. If any of those factors is drastically different then the relationship between variables may also be altered. I would argue that ALL of those fundamental principles have changed significantly and not in our favor.

Indeed, the economists that preceded neoclassical economics were much more focused on resource constraints and asset bubbles than our modern economics. Asset bubbles are not very well explained by modern economics and for a long time thought not worthy of study (Greenspan famously believed that it was worse to try to held off bubbles erroneously than let them form because we couldn’t tell what a “real” bubble was) and that has gotten us into the mess we’re in. Historically it was thought that mercantilism was the primary cause for economic problems and we are now more enlightened. But what if it was really environmental factors that aren’t properly accounted for? Is it any wonder that neo-classical economics arose right as the Industrial Revolution was taking hold? Perhaps mercantilism is a highly rational system in low growth capacity environments?

Of course economists recognize the importance of infrastructure, population and resource efficiency, but it doesn’t seem that they try to monitor it to determine whether their current models are still valid. Unfortunately the variables I am discussing are extremely hard (if not impossible) to observe and measure. Greenspan noted that we haven’t gotten any better at forecasting because it’s too difficult to pull apart the variables and I am not optimistic that we will ever be able to do better, although I will discuss some alternative models in the coming month.

The one thing that nearly everyone agrees with is that we have lived beyond our means the past three decades or more. Liberals focus more on the environment, population and consumerism, while Conservatives tended to focus more on budgets, entitlements and debt…well until “deficits didn’t matter” and Liberals started caring more. What both the pro and anti-government interventionists seem to be missing is that both sides were absolutely right that our lifestyle was unsustainable and now we are beginning to reap the consequences – yet both seem to argue that if only their ideology is chosen that we will get back on track. Basically it seems like people believe we can get a free lunch, but if you look at both economic and natural constraints, it is clear that we cannot.

Interestingly enough, Krugman himself had a follow up post that admits these problems indirectly. He points out that consumer spending is still above historical norms and that it is unclear how the government temporarily increasing demand will lead to a sustainable economy without global changes. All in all it seems that he is arguing that we have to try to do something, even if there is no long term plan, because if we do nothing things will be bad.

If the government is going to intervene, they should do it in a way that directly targets the basics of our economic environment. This involves researching/deploying sustainable and cheap energy, revamping infrastructure to be more efficient, cutting down on resource waste and reevaluating the role of labor. Obama has hinted that any bailout of the auto industry would have to account for those goals, but color me skeptical that it will. So far none of the bailout talk has truly grasped the enormity of the challenges we face. Moreover, we are in a weak position to try and accomplish those goals because we still have far too much excess in the system. Only when much of our current debt has been destroyed and we let demand destruction determine what is truly “necessary” will we be able to put our resources and labor to better use.

The Keynesian argument says that if deflation takes hold then businesses will cut back on investment and consumption because real interest rates will be high. Even if interest rates are only around 5-6% — historically average, but realistic because there will be many defaults – prices falling 4% would make a real interest rate of 9-10%. While this is true and will stifle small businesses and private innovation, the decreased interest rates on government debt (2-3%) and lower prices for standard of living will make it easier for the government to accomplish massive infrastructure projects and greatly improve our long term budget projections. In a perverted way, refraining from government intervention now will enable us to have better and more widespread government later, while also moving power away from private companies that have been irresponsible and to companies that were not.

People are still talking about whether to bailout or not and thinking about the consequences over the next few years; in reality we need to evaluate the consequences over the next few decades.