We are live at the Economist, as issues that I thought were settled by... 1829 return to haunt us all...
John Stuart Mill warned us in 1884 that:
What was affirmed by Cicero of all things with which philosophy is conversant, may be asserted without scruple of the subject of political economy--that there is no opinion so absurd as not to have been maintained by some person of reputation. There even appears to be on this subject a peculiar tenacity of error--a perpetual principle of resuscitation in slain absurdity.
--John Stuart Mill (1844), "Review of Thomas Tooke, 'An Inquiry into the Currency Principle' and Robert Torrens, 'An Inquiry into the Practical Working of the Proposed Arrangements for the Renewal of the Charter of the Bank of England, and the Regulation of the Currency'," Westminster Review 41 (June), 579-98.
Buy did I listen? No....
Economics: A response to Xavier Gabaix | The Economist: In response to "Why are firms saving so much?" Xavier Gabaix wrote:
Firms and households are saving a lot. There are at least three basic reasons for this. First, they still face a macroeconomic “tail risk” or “disaster risk”, as they perceive that the possibility of some big future economic shock is still high.... I suspect that [this] first force is the most potent.... What to do then? Under the “insurance against macroeconomic tail risk” view, the outcome is efficient...
And this makes me want to cry.
What is the "macroeconomic tail risk" which, Gabaix claims, it is individually rational for businesses to fear, and hence makes it collectively and socially rational for businesses to save and refuse to invest?
Gabaix never says.
Is it a fear that we will suddenly forget the past generation of progress in technology and organisation, and that only businesses with cash will be able to regroup and survive and evolve business models that will fit our reversion to the technologies of the 1970s? No. Is it a fear that workers will suddenly develop a very strong taste for leisure and that as a result real wages will have to rise massively, and that only businesses with cash will be able to regroup and evolve new business models that will fit the new higher-real-wages economy? No. Yet those are the only two "macroeconomic tail risk" shocks I can think of that would make it socially and collectively rational for businesses as a group to refuse to invest in new capacity right now—for, after all, whatever new capacity we build will be unusable if we forget our technological knowledge, and unprofitable if the real wage rises massively. Thus I believe that Professor Gabaix is hopelessly confused when he claims that "macroeconomic tail risk" makes it socially and collectively rational—"optimal" is the word he uses—for businesses to save rather than invest.
The macroeconomic tail risk that businesses today fear is not a Great Forgetting of technology and organisation or a Great Vacation on the part of the North Atlantic labour force. The macroeconomic tail risk that businesses fear is another breakdown of the credit channel: a situation in which banks dare not lend because they cannot themselves raise funds, and they cannot themselves raise funds because every possible source fears that the bank itself is underwater—has no skin in the game of intermediating the flow of funds and every incentive to gamble for resurrection by playing a game of "heads I profit, tails you pay" with its creditors. Asset price declines that impair the capital of financial intermediaries greatly magnify the principal-agent problems of finance, and it is that magnification of principal-agent problems and consequent cutoff of their own access to additional funding when they need it that underpin business desires to boost their holdings of safe, high-quality financial assets at the expense of their ownership of real physical capital.
This breakdown of the flow of funds through finance as a result of collapses in asset prices that have impaired the capital of financial intermediaries is nothing new: we have seen this going on at least since King Felipe II "the Prudent" Habsburg defaulted on his debts to the Fugger banking family in the sixteenth century. The subsequent flight to quality and fall in investment as businesses seek to raise cash reserves rather than invest in capital is also nothing new. The course of this process in 1825-6 in Britain was studied in 1829 by the French economist Jean-Baptiste Say in his "Cours Complet d'Economie Politique Pratique":
The Bank [of England]... forced the return of its banknotes... ceased to put new notes into circulation... was then obliged to cease to discount commercial bills. Provincial banks were... obliged to follow the same course... commerce found itself deprived at a stroke of the advances on which it had counted, be it to create new businesses, or to give a lease of life to the old. As the bills that businessmen had discounted came to maturity... each was forced to use up all the resources at his disposal. They sold goods for half what they had cost. Business assets could not be sold at any price. As every type of merchandise had sunk below its costs of production, a multitude of workers were without work. Many bankruptcies were declared among merchants and among bankers, who having placed more bills in circulation than their personal wealth could cover, could no longer find guarantees to cover their issues beyond the undertakings of individuals, many of whom had themselves become bankrupt...
Say deserves credit and kudos for uncovering and analysing this problem in near-real time. And Say's successor John Stuart Mill deserves kudos for being the one who came up with the answer: firms are desperate to hoard cash and not to invest in expanding capacity because they fear the "macroeconomic tail risk" that they will be unable to obtain credit when they need it. Solve the problem by having a central bank, and have the central bank lend to them, and thus give them confidence that if businesses do indeed come to their last resort that the central bank will be there to be their lender. As Mill wrote:
[I]f the Bank of England [has] occasionally aggravated the severity of a commercial revulsion [through mistaken policies]... it [has] rendered invaluable services during the revulsion itself by coming forward with advances to support [illiquid but] solvent firms... at a time when all other paper and almost all mercantile credit had become comparatively valueless. This service was eminently conspicuous in the crisis of 1825-6, the severest probably ever experienced.... This function... is so entirely indispensable, that if the Act of 1844 [restricting the size of the balance sheet of the Bank of England] continues unrepealed, there can be no difficulty in forseeing that its provisions must be suspended... in every period... as soon as the crisis has really and completely set in...
Or as my teacher Charles Kindleberger wrote in the final sentence of his book "Manias, Panics, and Crashes": "there must be a lender of last resort."
From this perspective, the depth of the current depression—what Charles Kindleberger would have called "overtrading, revulsion, and discredit", what John Stuart Mill would have called a "commercial crisis", and what Thomas Robert Malthus would have called a "general glut"—is a sign that the world's central banks and Treasuries have not yet done their job as collective global lender of last resort, and need to step up the pace to make businesses confident that credit will be available in the event of more bad news for asset prices.
What makes me cry is that this entire set of issues does not appear to be on Xavier Gabaix's radar screen at all. It is as if he has never heard of any of it. Now it is true that this was cutting-edge economics once. But that was 1829.