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Thoughts On The Economic Team: Right And Wrong

Posted by MIKKEL FISHMAN, Economics Editor in Economy.
Nov 24th, 2008 | Comments

Obama has officially unveiled his economic team to generally positive reviews from people I often agree with (e.g. here and here) considering their mainstream nature. Both Summers and Geithner are near the top of the list when it comes to pragmatic capitalists. Summers was very influential in the Clinton Administration; he served as the Secretary of the Treasury and was on the front lines before then. Both men have been actively involved in helping to solve financial crises of the 90s and today. My initial impression is that Obama picked the two best candidates for navigating through the crisis under currently held academic assumptions. They definitely are pro-market but recognize the value of regulation.

That said, I believe that currently held academic assumptions are wrong. Fortunately, most of my argument can be summed up in the two recent posts on TMV by T-Steel and Jerry Remmers. It doesn’t matter how much of an expert you are in a field if the basic assumptions are incorrect, and I feel that modern economic studies ignore some very real and obvious truths that make proposed policies not only ineffective, but dangerous. T-Steel really got to the heart of the matter by pointing out that we are at the end of cheap credit, and so many of the ideas that Summers and Geithner hold on to will not work. Furthermore, merely stimulating the economy until credit can be reestablished — the proposed solution to avoiding the Great Depression — ignores natural principles that comprise the foundations of economics.

A good comment was left on my last post in regards to “I hate to say it, but from my perch I am desperately hoping that everything fails so quickly that we can’t keep trying to save it. At least then we will be faced with reality in a way where we can work towards something positive, instead of spending the next 30 years merely trying to pay off the excess of the last 30 and not moving forward at all.”

But I have to further confess, the portion quoted above frightens me even more. It strikes me as a fantasy to believe it can all just crash–and then we will suddenly be able to “work towards something positive”

It made me think of an analogy I feel is apt and perfectly captures my thoughts on the current economic approach.

I likened the current crisis and our response to a national disaster, where the medical response in treating injuries changes based on the scope of the disaster. When there is a large scale event with many injuries, medical teams triage the victims into those that face certain death in a short time, those that are severely injured and may get worse but not critical and those that have light injuries. In small scale disasters, most resources are spent on those that are at the critical stage and as much as possible is done to try and save those lives, even if it means ignoring the severely injured and taking a chance that some of them will become critical as well. If a person does move from “serious” to “critical,” they are reprioritized and given immediate attention.

However, in large scale disasters that completely dwarf the amount of resources available, there is a decision made to give the severely injured the most attention even if it means that all the critically wounded will die. This is because very few critical patients can make it regardless of how many resources are given to them, and by ignoring the seriously wounded, it guarantees that many people that might have been saved will die as well. It no longer makes sense to wait until the seriously wounded become critically wounded, because there are so many of them that waiting guarantees that emergencies will swamp the system.

I believe that we are in a large scale disaster but our policy makers are treating it like a smaller and isolated disaster like the type seen in the 90s in Asia, Russia and Japan. This analogy also helps explain why all these bailouts come seemingly out of nowhere, and are literally going from “we are slightly injured but ok” to “the entire system will collapse if nothing is done” within the span of only a few days. The structure of our financial system exacerbates this problem and I hope to take time to discuss it in further detail within the coming weeks. I also feel that economists have forgotten some very basic principles.

Money is now a fully abstract concept, but it represents something very tangible: production as a result of utilization of natural resources and labor. Since natural resources are finite, the more efficient we are in consuming them, the better our lifestyle will be. What we are witnessing is the culmination of a period where there was too much inefficient consumption and thus wayward destruction of many natural resources. By arguing for massive increases in debt, economists are in effect arguing that we should boost our utilization of natural resources further, even though we already have more stuff than we need and do not have the technology (both physical and cultural) to either a) increase the extraction of natural resources cheaply and/or b) produce goods more efficiently with the natural resources we can extract.

Therefore, while their models tell them to inject money into the economy in the right way and everything will fix itself, in reality there are two options: the money does not flow into increased production and therefore creates massive inflation, specifically in areas where there is not much of a glut (e.g.; food, energy and healthcare) at the expense of areas where there is (housing, cars, discretionary goods); the amount of production does increase across the board, but only by ramping up resource utilization in an increasingly inefficient way, quickly exhausting cheap resources and causing huge supply shortfalls.

In short, by refusing to recognize the limits of our resources and focusing primarily on the critically injured, our government is introducing policies that have a good chance of bringing the “seriously injured” into the “critical” category in large waves. This is a recipe for pain and suffering, and I think that if we had been spending the same amount of money constructing emergency social nets and otherwise helping the seriously injured, we would be in a position to weather any calamity. Instead we are pouring resources down the drain on institutions that are impossible to save, and have a good chance of finding the entire country on life support in the coming years.

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Jim_Satterfield

Furthermore, merely stimulating the economy until credit can be reestablished — the proposed solution to avoiding the Great Depression — ignores natural principles that comprise the foundations of economics.

Economics in the real world has almost no principles. It is a human endeavor. It is not physics with Newtonian rules or even those of Einstein.. It more resembles chemistry, wherein the immediate environment affects what happens. Chemical reactions can vary wildly according to temperature, pressure ratio of materials to one another and other factors. In the case of economics that environment includes communications, trade, relative costs, individual psychology, group psychology, rules of law, government stability (or lack of same) and about any other influence on the flow of money or the human psyche that you can think of.

mikkel

While all that's true, you can clearly overlay aggregate economic growth on top of measurements of aggregate physical resources that are currently utilized (whether you're talking about oil consumption, CO2 emissions, forest coverage, whale population etc. it just depends what technology and specialization you have) and they will be a very close fit. Our system requires exponential economic growth and has exponential resource consumption...standard of living increases or decreases based on which exponent is bigger. Whenever we have exhausted a resource, we either move on entirely or (if it's renewable) figure out how to use it more efficiently. There is an argument to be made part of this is true because population also grows exponentially when resource constraints aren't limiting, although we've entered the flattening of the logistical population model and are still seeing an exponential increase in resource usage because it is necessary to our economic system and we want to increase standard of living.

While I agree that all the factors you state drastically affect the relationship of economic variables (and I have the same criticism of economic equations which I've mentioned on this site time and again) economics as a whole is simply an abstract model to allocate natural resources/labor across a population and forgetting that -- like most economists do -- is very bad.

GeorgeSorwell

I appreciate your taking the time to think about my comment.

I have no idea what's orthodox or unorthodox in economics, let alone what's impossible, as opposed to what's merely unthinkable. So I'm not sure what to think about your diagnosis.

Thanks for the clarification.

DLS

Mikkel, first be aware that there is hype and overblown panic and sensationalism about the economy. (Aside from the tendency to sensationalism, the media, who was part of the Obama campaign if only unofficially, had an obvious motive to make things look worse before the election than they might be.)

Second, there is common, normal, sensible reluctance to have government intervene in this as in other matters. Why risk more harm? Does anyone in Washington know exactly what to do? No.

Third, when considering possible deflation, this is something new to the developed world other than Japan as a serious issue -- we've been in an inflationary era for decades (during the later two, experiencing a dimunition of inflation to the point nobody thought of it until the recent run-up in oil prices that made the slump materialize).

Fourth, this is an uncertain thing, as J-Sat has already explained. Welcome to the world of that infamous phrase, "the social sciences."

As a book I have puts it, better:

"... The key to the whole issue is the interaction between uncertainty and the fact that the policy of monetary expansion without limit [to cure or prevent deflation] has side-effects, costs, and risks. It has been the neglect of this aspect that explains why western economists have tended to view deflation as next to impossible in an economy presided over by a normally competent central bank. Once you realize the implications, a future including periodic bouts of deflation becomes readily imaginable.

Look at the feeble growth of the Japanese money supply, the critics say. The Bank of Japan should be creating money hand over fist! But it _has_ flooded the system with liquidity and made the banks flush with cash. The problem is that it cannot _make_ the banks lend or borrowers borrow. ... The banks would much rather sit on their piles of cash, even though it earns them next to nothing. At least it doesn't expose them to the danger of bad debts.

Moreover, if the banks do not respond normally to stimulus from the monetary authorities, borrowers do not respond normally to any stimulus from the banks. Because of the recent history of excessive investment, the corporate sector is more than usually insensitive to the normal prods and incentives, while consumers are liable to be extremely pessimistic, cautious, and risk averse. ...

This point can be generalized. What makes deflation difficult to shift is the ultra-important human element. Deflation gets into people's heads: their attitudes, expectations, and reactions. Things can reach a stage that you could say that deflation is all in the mind. ...

... I think it unlikely that the Fed would unleash a large unorthodox monetary expansion _before_ the onset of deflation. It would not have the political or market constituency to support such a move. ...

... What explains central banks' hesitance to take really bold action to head off deflation? I think the answer, as with so much else in economics, is uncertainty. If the central bank knew that a monetary expansion of a certain size would be enough to stop deflation, the costs and risks would be relatively easy to weigh up against the intended benefit of the end of deflation. But it _doesn't_ know this. The requisite amount may be 10 or 100 times the imagined amount, or a tenth of it, depending largely on the expectations of people and businesses -- and that will depend a great deal on whether these people and businesses are confident that the policy will be sustained.

This means that a rational central bank will want to tread gingerly, hoping that a small dose of the treatment will do the trick and thereby minimize the side-effects, costs, and risks. ... "

mikkel

DLS, what basis do you have to argue that there is hype and overblown panic? When you look at debt loads they are far and away above what they were before the Great Depression. When you look at how much the economy needs to grow to service those debt loads, it will require a massive consumption of natural resources (I just found a couple of academic papers that compare the relationship that I'm studying) or a previously unseen increase in productivity.

The more I read the more it becomes clear that the only way to clear out the debt is either through massive deflation, hyperinflation, or gigantic utilization of natural resources. They have claimed that they will never let the first happen, and the second is a real possibility because we are constrained by the third.

It's all fine and well to say that economics is a social science (it is) but that just means that the influences on the variables are largely socially determinant. At the end of the day, the entire system itself is simply a way to assign values to goods that are a result of human and physical resources. My argument is that the values assigned are wildly off and in order to correct them we either have to purge the system (either through deflation or hyperinflation) or make tons more stuff. Actually to be even more accurate, a lot of the value is based on future expectation of growth, so it's about the rate we make more stuff too.

As a side note, while I'm putting the pieces together on this relatively independently, I'm going back and reading more and finding out that it is a long standing critique. The more I study the more it seems like our entire view of what economics tells us is has been determined by mechanization and petroleum giving such an enormous labor and energy boost that it obscured the truth I'm talking about.

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