Friday, 8 October 2010

There is something wrong at the Federal Reserve.

When one senior person in an organisation talks nonsense, that doesn’t prove much. But when the numbers start rising to significantly above one or two, the suspicion arises that there is something wrong with the organisation itself.

I highlighted some nonsense emanating from two Fed people here.

Plus there is an ex-Fed economist (Arnold Kling) who says on his blog that he is having difficulty understanding Modern Monetary Theory. However his errors were put right by those leaving comments on the blog. Which raises the question: who is the more economically clued up – professional economists or the best bloggers?

That is three individuals. Now there is a fourth. Alan Greenspan (the one person, if there is one person, responsible for the credit crunch) has an article in the Financial Times today. The article is hogwash. Here is the first paragraph.

Although rising moderately this year, US fixed capital investment has fallen far short of the level that history suggests should have occurred given the recent dramatic surge in corporate profitability. Combined with a collapse of long-term illiquid investments by households, they have frustrated economic recovery. These shortfalls, the result of widespread private-sector anxiety over America’s future, have defused much, if not most, of the impact of the administration’s fiscal stimulus. Moreover, the activism embodied in such programmes has itself stoked the degree of anxiety.

“Long term illiquid investments by households”?? Well presumably that’s just a fancy name for houses. At least housing is far and away the biggest “illiquid investment” that the average family makes. Now given that there has been a GROSS OVERINVESTMENT in houses, what on Earth does Greenspan expect or want heavily indebted households to do? Run out and burden themselves with more NINJA mortgages, buy more or bigger houses and go even further underwater?

As to businesses, the main reason they are not investing as these three surveys show, is not, as Greenspan claims “widespread private-sector anxiety over America’s future”. The latter is an important element, but if there is one overriding reason for not investing it is plain simple lack of demand.

1. See here (p.28), 2, See here (page 14), and 3, See here, page 26).

In the next few paras, Greenspan repeats several times that it is an aversion to illiquid risk that “explains a large part of the anaemic recovery”, to quote.

So the basic purpose of an economy is indulge in risk? I thought the basic purpose of an economy is to provide consumers or citizens with what they want. If there is excess unemployment, then there is scope for giving citizens more of that which enables them to have more of what they want and employ the unemployed. And the stuff that kills the latter two birds with one stone is . . . wait for it . . . . money!! I.e. money needs to be fed into household pockets or “Main Street” pockets, not in to the pockets of Greenspan’s friends: the crooks and fraudsters of Wall Street.

As to the amount of investment needed to meet this demand from the consumer, well businesses can decide for themselves what level of investment is appropriate. They don’t need Nanny Greenspan encouraging or discouraging them from making investments.

Greenspan is a classic example of a phenomenon I highlighted here. That is, the tendency to lose sight of what economies are for, and instead mess around with important sounding concepts like “illiquid investments”.

Greenspan also attributes much of the problem to “the widespread major restructuring of our financial system”. What restructuring? The too big to fails have been left alone, i.e. they are the same size as they always were. (With the exception of the U.K. where the merger of Lloyds and HBOS made the “too big to fails” even bigger!!!!)

As to criminal or fraudulent mortgage practices, there has been next to no clamp down. As to Basle III, it’s as weak as water. Basle III won’t cause banks any lost sleep.

Deficits crowd out private sector investment?

Greenspan then makes the bizarre claim that a significant part of the problem is that the deficit has crowded out private sector investment.

I’ve just done a quick Google search for “deficit “crowd out” and investment”. The various articles and papers available seem to be inconclusive on whether deficits do crowd out investment. Indeed, one of them explicitly states in the summary that the jury is still out on this one.

But even asking the question as to whether deficits crowd out investment displays an ignorance of economics. Reasons are thus.

There are two basic reasons for running a deficit. One is as a substitute for tax. That is, government abstains from covering all its spending with tax and funds a portion from borrowing. That involves wading into the markets, and upping interest rates with a view to attracting funds to cover the relevant spending. (BTW, I’m using non Modern Monetary Theory phraseology here, but never mind.)

Now that IS BOUND TO CROWD OUT INVESTMENT! Indeed, crowding out private sector activity in general (including investment) IS THE WHOLE OBJECT OF THE EXERCISE!!!

That is, private sector activity has to damped down to make room for the relevant public sector activity. In this circumstance, anyone who complains about “crowding out” needs to do a basic course in economics and logic.

The second reason for deficits is to counter a recession, i.e. to do a bit of “Keynsian borrow and spend”. Here, obviously if government just borrows and spends period, then interest rates would rise, and crowding out would occur. But governments / central banks don’t do that. That is they certainly do not let interest rates rise in a recession. In fact they do the reverse: cut interest rates, which makes it easier to borrow and invest!

All in all, the question “do deficits cause crowding out?” is a bit like asking “are fires dangerous?” The answer to the latter “fire” question is “the question is so vague, that it’s a useless question, but ultimately the danger depends on who’s in charge of the fire, what the purpose of the fire is, where it is, how big it is, and a dozen other factors.” In short, don’t ask silly questions.

If Greenspan had his way, matches and cigarette lighters would be banned in case they caused another great fire of London.

And finally, Greenspan bemoans the damaging effect that bank regulation will have on “financial innovation”. Yes, we really need those Ninja mortgages up and running again, don’t we? And then there are those fiendishly clever and “innovative” people at hedge funds, Long Term Asset Management being the main culprit, which nearly brought the U.S. economy crashing down before the credit crunch. And then there are those clever clever CDOs the main aim of which is to hid toxic stuff from the innocents buying the CDOs.

We need “financial innovation” like we need a hole in the head.

Afterthought (9th Oct): More critical comments on Greenspan here.

Afterthought (4th Apr 2011): two more people of the view that Greenspan is past his sell by date: here and here.

1 comment:

  1. Ralph,

    Kling has a hard time understanding modern monetary theory, not Modern Monetary Theory as in MMT. Stephen Williamson is a well respected academic macro researcher also associated with the Richmond Fed. He has absolutely nothing to do with MMT.

    Anyway, isn't Kling at GMU? Hardly a representative sample if you want to start drawing inferences about the economics profession.

    The "simple lack of demand" question is interesting. In my experience, MMT types are quite keen to point out the abject stupidity of mainstream models, but are also generally in the weird position of not really having well developed models yet believing in them absolutely.

    How do you know that the problem is "simple lack of demand"? The fundamental epistemological uncertainty here is not easy to resolve. If you can extrapolate the correct trend (stationary or unit root, e.g.) from the time series, then there is an obvious space for policy. That is, you can say that deviations from trend are inefficient and therefore that policy interventions can increase efficiency.

    But it would be hard to do this from a position of sincerity, since you obviously do not and cannot observe the underlying data generating process. Since you do not know the true model, you do not know the trend and cannot identify inefficient deviations in output with certainty. The neoclassical explanation is pretty crazy too, IMO (rational reaction to technology shocks), but they have the right approach to the fundamental uncertainty surrounding what we know about the data and how we think we know it.

    Bob Solow was saying back in the '60s that economics was over as a science and that we know everything we need to know about managing the economy. They say history rhymes and Post Keynesians are still humming the same tune (largely, at least).

    Not giving this problem the credit it deserves makes MMTers look short-sighted, and it makes them subject to partisan affects when cooler analysis would be beneficial (they know they are right, and therefore that their opponents are naive or mendacious). Extrapolating past trend into the horizon-less future is what got our financial sector into this mess in the first place.


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