Notes to Self: What Are We Doing?

Nobody--save a few fringe academics like Casey Mulligan today and U.S. Depression-era Treasury Secretary Andrew Mellon and his epigones in 1930 (that's why it is called the Great Depression)--believes in the rule of the "free market" in a financial crisis. And Sweden in 1992 is a definite precedent for what we are doing now.

But what are we doing now?

I am not sure, but I think I would put it this way:

Back in 1844 British Prime Minister Robert Peel laid down the then-consensus principle that the government had to take control of the money market in emergencies: that commitment to the "free market" went out the window in a financial crisis because both the price at which bankers could get cash and the amount of cash in the economy were too important as determinants of the welfare of the people to be left to market forces.

In 1936 John Maynard Keynes argued that that was not enough: that the government had to more-or-less comprehensively take control of the overall level of investment and related forms of spending--that they were too important as determinants of the welfare of the people to be left to market forces.

In 1963 Milton Friedman argued that if the government took control of the price at which bankers could get cash and the amount of cash in the economy at all times--not just in crises--intervened constantly to keep the money stock growing steadily--that you would never get into the kinds of situations Keynes feared in which the government had to comprehensively take control of the overall level of investment and related forms of spending. And Milton Friedman more-or-less won the argument.

Today we seem to be moving back from Milton Friedman's doctrine toward, or perhaps beyond, Keynes's. What the Federal Reserve and the Treasury seem to be saying now is that Friedman was wrong. It is not enough if the government takes control of the price at which bankers could get cash and the amount of cash in the economy at all times. In emergencies, at least, the government must also take control of the discount the market applies to other assets that are not as good as cash because they are risky--that the price of risk as well as the terms on which bankers can get cash are prices that are too important for the welfare of the people to be left to market forces. And to control the price of risk we need to control (a) the quantity of risky assets outstanding, and (b) the capital of banks. Which seems to be what we are doing.

I am not sure whether this is some kind of halfway house between Friedman and Keynes, or whether we are going beyond Keynes, or whether we are heading off in some other direction. But this appears to be where we are going.

Comments

[je0jhetijehop]

Dude, say you gave $.5T to banks. What would they do with it? They were investing into derivatives and CMOs all along.

[Matt]

The first issue we have to decide is whether the new order includes a strong global bank, or global governance.

If global trade continues, then yes we will, China will get its Brenton Woods. If global trade does not grow in the new order, then we can stay with what we have.

I expect the former, global trade will continue to grow, albeit with higher value goods. As global trade grows, the aggregate stability demands something strong, globally, that is wealthy and profit oriented.

This means that the new equilibrium, for nations, is a smaller share for the government pie, having to cede some both up to the global bank and down to the financials. Nations will be required to accept less aggregate stability, but more individual and corporate stability. On the whole the global aggregate will be more stable, national government will need to be better managed.

Before national governments can really go to auction and get their share, the global bank has to get its share, the transactions in complete markets can distribute the rest. The auction first estimates the long pole, the global bank which will have the longest time constant. This will follow from Ramsey theory, I believe. After that the second, third and so on modes will seek equilibrium.

I am waiting for China to weigh in here.

[dilbert dogbert]

Didn't that Marx guy, not Groucho, have something to say about "Commanding Heights" and public ownership? He would be having great fun if he was alive today.
Define what the state of current system is; capitalism or socialism. What is the mix now?

[Don the libertarian Democrat]

Who Says Capitalism Is Dying?
Some good news:

http://www.nytimes.com/2008/10/11/world/asia/11china.html?hp

"BEIJING — Chinese leaders are expected to allow peasants to buy or sell land-use rights for the first time, a step that could draw hundreds of millions of farmers more firmly into the city-centered market economy.
The new policy, which is being discussed this weekend by Communist Party leaders and could be announced within days, would be the biggest economic reform in many years and would mark another significant departure from the system of collective ownership and state control that China built after the 1949 revolution."

Read on.

Who says capitalism is dying?

[bryan]

At this point, what purpose remains for the existence of bank corporations, other than administer retail branches?

[christofay]

Matt is introducing how the Chinese will have a seat at the table while the west hands up some banking power to a neo IMF. The Chinese are there due to being the answer of who has a trillion dollars. Looking at the serial malfunctions, Iceland, German investment companies, AIG, there is a global run where the United States is only the biggest in line. We are in a compromised position to say the least.

What about capitalism at the local level in China? Some of that peasant farm land could be a dusty rice bowl. That would be a Milton Friedman gift. Up to date capitalism is the Chinese state negotiating capital flows.

[Steve]

Excellent analysis regarding China’s sovereign risk and economic outlook:

http://www.garpdigitallibrary.org/download/GRR/2089.pdf

[albrt]

The government does not control the amount of cash in the economy when it does not control velocity (i.e., requires zero lender reserves and allows anybody with an Ivy League degree and a Visa platinum card to write credit "insurance").

Regulate or die.

[fgw]

That was a very helpful and clarifying analysis. But I thought the root of the problem was that for years greenspan and the neo-liberal consensus deliberately underpriced risk. There was always some grave challenge that needed to be addressed, Y2K, Mexico, always with lower interest rates. And the American economy became more and more dependent on the financial/hedge fund industry as wealth generator, compounded by the growing non-competitiveness of US manufacturing and technology in the wake of globalization. So Friedman and the mantra that the free market can best distribute risk, aided by innovation in the financial industry, might have been true, if the economy hadn't been so dependent on continually keeping the fire stoked.
I remember sitting at a dinner table, one of a group of scientists as guests of a hedge fund manager. And as he described what it was he did, we turned to each other and realized what he was describing was called parasitism in our field. I think of the last 30 years as trying to grow a garden of parasites. If you keep on watering the plant the parasite grows on, it can keep on happily sucking up more and more phloem. Until the roots of the plant rot.

[J Thomas]

We were importing nore than we exported. In the USA we argued that we mustn't impose tariffs etc because foreign nations would retaliate.

It might be supposed that the dollar would be devaluated until our exports went up and our imports went down. But various nations (particularly china) pegged their currencies to the dollar so that the dollar could not be devaluated relative to them. So imports did not go down and exports did not go up.

The rationale for the pegging was explicit for ecuador. They say their people are desperate for low-paying jobs, and pegging to the dollar -- at the right rate -- will give them jobs producing for export, they'll have higher exports and lower imports. Their people will have less stuff for themselves but they will have jobs.

In the USA we argued that people who couldn't find jobs should learn to work smarter so they could get great jobs. There was some anger at illegal immigrants but a consensus that most of them were taking low-pay jobs that americans didn't want. There was some anger at legal immigrants taking good jobs from americans, but a whole lot of jobs were being outsourced anyway. If the foreigner got the job and came here at least he paid US taxes. If he got the job and stayed home, we got nothing.

It would have been politically difficult for the government to arrange that we import less. Nobody wanted the US standard of living to go down. Do without or make the stuff ourselves, at low wages ... both unpopular. And it's very expensive to make oil.

So we bought stuff and paid with dollars, and we needed something to sell or else take out loans, so foreigners would keep selling to us. The government couldn't smooth out bubbles -- foreigners investing in our bubbles were how we paid for our imports.

The housing bubble was a natural -- you can't import housing.

The derivatives mess was not a bug but a feature. We needed foreigners to buy them to pay for our imports. They were not badly regulated, they were regulated just right to get foreigners to think they were worth something.

The banking industry might need changes, and will get changes, but not because the old approach failed. The old approach worked perfectly at the goals it was assigned. They were just improvident goals.

Now we will have to reduce our imports. And we will try to find ways to export more. Our consumers will buy less. Officially our standard of living will go down. Lots of americans will take lower-paying jobs. We will do our best to develop alternate energy because we can't afford oil. Find ways to do things cheaper.

We could save a lot of money by cutting back our military. But we might choose to increase it instead. That's a political choice. We could save a lot of money by eating significantly less meat. How much to subsidise our cattle industry is another political choice. Etc.

Is there any chance the US dollar will stay the reserve currency? Not likely. The weaker we get the fewer other nations will peg their currency to ours. The weaker we get the less problem we'll have with illegal immigrants. Etc.

Our current shakes are just withdrawal symptoms. The crack dealers have cut off our supply. The big challenge will be to set up a sober economy and pay off our debts.

Or maybe we can have a war and cancel the debts? But how would we pay for the oil? We need to find out how to do energy-efficient warfare.

[Chip Poirot]

I think you are being too generous to Friedman. Friedman wanted a constant growth in the supply of money to control inflation. He did not want a constant flood of liquidity-in fact that is exactly what he opposed.

The silly 1960's debate of "only money matters" and "money doesn't matter at all" was in essence a non-debate. Friedman said money could not effect real variables in the long run so efforts to stimulate the economy through monetary policy were doomed to fail. That means that Friedman though partially right about Fed policy in the Great Depression was theoretically inconsistent. And of course, the monetarist experiment in the 1979-81 period entirely failed.

The real winner in the monetary policy debate in the end is Keynes-because Keynes himself knew and understood that money really did matter. And it has been to a large degree (with some notable exceptions) Post-Keynesians like Davidson and Minsky who worked out the basis of a theory where money is real.

As Davidson is so fond of saying it's "liquidity, liquidity, liquidity". I may not agree entirely with Davidson's implicit point that we should flood the system with liquidity all the time-but in this instance-the response to a crisis-Davidson is 100% correct.

[Matt]

I still forget to write the yield curve in frequency instead of period, it makes a big difference in understanding the role of liquidity.

The yield curve, written as a spectrum, result in a very long tail, where the fed is pushing on this tail, the short term region covers about 80% of the curve, longer term focused around the center.

Written as frequency, the peak at 20 years (1/20) vs the 30 year (1/30) is pronounced and more abrupt, meaning that the economy is getting a clearer picture of the 20 year future, mainly good news. This should hold and we should be at bottom, we understand the future much better than we did a month ago. We learn very fast in a restructuring, that is why we do it.

[Blissex]

«The banking industry might need changes, and will get changes, but not because the old approach failed. The old approach worked perfectly at the goals it was assigned. They were just improvident goals.» I like your analysis a lot; it paints a nice picture, of the sort that results «But how would we pay for the oil? We need to find out how to do energy-efficient warfare.» Iraq was supposed to be the answer to that question -- Napoleon's army marched on its stomach, modern armies on its oil pipelines (the Russians even had field pipeline battalions...). Garnering control of one of the last large reserves of oil for military purposes and leaving it in the ground may have been a goal of Iraq since the beginning. Nobody has forgotten how tremendous was the advantage of oil powered navies wrt coal powered ones, or the scramble for oil by the German army in the last years of WWII, or that USA air superiority depends critically on colossal amounts on aviation fuel. Least of all the chiefs of the logistics-obsessed USA armed services. Iraq is the result of that.

[Blissex]

«The government does not control the amount of cash in the economy when it does not control velocity» That's a concise statement of why Friedman was an imaginative fool: when he talked about "the quantity of money" he was using the product of two unknowns (the stock and speed of means of payment) as if it was a "quantity" and not a fantasy he had. Velocity is particularly difficult to control too. «(i.e., requires zero lender reserves and allows anybody with an Ivy League degree and a Visa platinum card to write credit "insurance").» But elected officials are largely sponsored and paid for by the class of "Ivy League degree and a Visa platinum card" holders, so why should they limit the profit making of the best-and-brightest with stupid restrictions like reserves or standards? Indeed, recently elected officials have made it a requirement for central banks to deposit very large reserves with banks, and for banks to use insured deposits to cover the losses of investment banks, in order to save the positions of rent and power that their "Ivy League degree and a Visa platinum card" sponsors have acquired. Anyhow, very perceptive comments by many, particularly, {J THomas}, {albrt} and {jgw}.