Ebbing economic tides

Rising tides usually lift all boats, while ebbing tides lower most if not all of them. When the economy grows, people don't mind when some prosper inordinately as long as they themselves are as well or better off than they were before. They like to believe they will also prosper. When the economy shrinks though, the easiest gains are often at the expense of others. For that reason, there is a strong counter tendency towards egalitarianism in times of economic stress to prevent this. We must find a commonality of purpose to pull together to overcome our hardship. We must share in the punishment and reward alike and strengthen our resolve to stand united or divided we fall.

Market Fundamentalism

Market fundamentalists believe markets can handle anything the world sends at them, except government. They are fooled by government, naively misled by it, unable to anticipate it, or induced to take advantage of it, forced to misbehave by it, or cynically exploit it. Whenever markets fail it is the fault of government, they were only doing what was expected. The devil made them do it. How lame. Well since everything is the government's fault, it must be their responsibility to fix.

Debt and Deflation

The banes of credit crises are debt and deflation. Debt is the destruction a credit crisis leaves in its wake. Attempting to liquidate it can result in deflation and the ridigity of debt then results in a vicious cycle. Since deflation increases the real interest rate, it makes it more difficult to repay debt while making it more imperative to do so, leading to more liquidation through default or reduction, and more deflation. Deflation must be prevented and debt defused over time. Reasonable inflation can help defuse it, allowing debt to be liquidated and easing the drag on the economy from it.

Austrians and Economics

Markets good, government bad. Markets never fail. When they fail, it is always the fault of government. Austrians suffer from an extreme anti-government bias that taints all their reasoning. Since government always exists and is always to blame, it is impossible for markets not to fail. Austrians should give up before they start since they can’t use history to establish anything. All we have is assertions that something else will be better, even though that something suspiciously resembles what we had in the past and were not happy with. At best it is assertions and wishful thinking. Wishful daydreams of ancient golden age market utopias. A kingdom for ‘the right monetary policy’. Austrians offer little in the way of explaining, preventing, or responding to business cycles than interest rates and ideology. That summarizes Austrian economics in all its tediousness and answers any question that arises.

There is some truth in credit induced booms and busts. Austrians explain a business cycle, but not the business cycle. There are more reasons than low interest rates for booms and more causes than high ones for busts. In this one it was far more relaxed lending standards than low interest rates. While lower interest rates can, although not necessarily do, relax lending standards, that is not the only way. Higher monetary velocity can as well and the central bank has even less control over that than interest rates or money. It seems evident from experimental work that bubbles are inherent to market processes.

Central banks make mistakes. So do markets, and no, they are not all due to government however fervently Austrians want to believe. The ability to make mistakes also implies the ability to correct them. We live in a more complex world than Austrians admit. While money is predominately created by the central bank, they are not alone in creating credit. While interest rates are powerful, other things such as lending standards and monetary velocity are as well. While one answer for everything may be satisfying to the zealot, it leaves a lot to be desired for the rest of us.

It is possible the central bank can’t really prevent cycles, that the most they can do is redistribute their occurrence, frequency, and magnitude, but if it is possible to make them worse it should also be possible to make them better. While accidents may happen, our actions in response need not be accidental.

Now both markets and government are subject to human foibles and both can error. Even Adam Smith thought interest rate caps prudent to prevent bad lending. Certainly the Fed should have watched the burgeoning of credit and taken steps to limit bad lending which was what made this boom unsustainable, and it should probably be doing more rather than less now to prevent further damage, but those are errors of omission rather than commission.

Credit Crisis Severity

Why do some asset booms end so much worse than other asset booms? Why did the housing boom end so much worse than the tech boom for example? The answer is amount, debt, and expectations.

The amount most have invested in equities is much less than they have invested in real estate, partially due to less leverage, partially due to the necessity of shelter, and substantially due to real estate coming in such large units.

Consider an asset that rises from price p to price 2p before falling back to p. Anyone that held it for the duration would be no better or worse off. Someone that sold at the peak would have a gain of p, and the buyer would have a loss of p when the price fell. In total, there is no gain or loss, only a transfer from the buyer to seller. It is zero sum to first order. Any losses leave no debt behind. Wealth was not created or destroyed overall, only redistributed.

Now consider the same situation where the asset is acquired with borrowed money. Since these asset prices are afforded by incomes which change little over a boom, they will often vary roughly inversely with interest rates, with rates falling by half before rebounding. Anyone that held it for the duration and did not refinance would be no better or worse off. Anyone that refinanced the same amount to a lower fixed rate at the peak would be better off, while anyone that refinanced to the full amount at the peak may or may not be worse off depending on the terms of the loan, but may be much worse off than they expected if they did not anticipate the decline. Someone that sold at the peak would have a gain of p, and the buyer would have a loss of p when the price fell. The lender will also have problem if the owner cannot make the payments, must sell the asset, or even is no longer willing to pay, as the asset no longer provides sufficient collateral for the loan. This is not something the lender expected. Though this is also zero sum to first order, expectations make the result worse. Some will have consumed temporary gains leaving themselves more indebted. Some will have lost any equity they may have had. Some won't be able to afford it. Some won't be able to repay the loan if they have to sell. Some won't want to pay for something that has lost so much. The lender will suffer unexpected losses. Losses often leave debt behind, debt being the residual of crushed expectations. Wealth was not created but it very often is destroyed by being consumed during the boom leaving only the debt afterwards.

So what makes equity markets so much different from real estate markets? Equities amount to much less then real estate in most instances. Equities are much more liquid in most cases. Equity markets offer much lower leverage to retail investors, a factor of 2 (50%) compared to 10 (90%) or more for real estate. Equity markets are callable and marked to market daily, limiting losses, while real estate is at the option of the owner and marked to market only on sale. Equities are volatile, fast, and changes are expected, while real estate has low volatility and changes slowly with considerable inertia and momentum.

Happy and Not-So-Happy Markets

The problem with the Efficient Market Hypothesis, EMH, is eventually proponents have to assume it and whatever happens becomes its confirmation. This makes it unprovable and useless, but better that than wrong.

How compatible are efficient markets and psychology? Can psychology just be treated as an exogenous variable to efficient markets? I would call this the happy markets theory, or the markets are efficient except when they are not theory.  Was the market failure the failure to anticipate such a change, to anticipate the effects of such a change, or in the reaction to such a change? Were prices too high before, too low now, both, or neither?  What are markets failing to anticipate next? What are they overreacting to now?  Will they fall by half or double tomorrow?  Are prices anything other than the whims of participants?  There is nothing wrong with treating psychology as exogenous other than making a mockery of EMH. It is notable how the same reasons are used at times like these, psychology, technology, .. and there may well be some truth in them, but such truth would be far more significant than the meaninglessness of EMH.

A Hyper-Ricardian Hypothesis

Conservative economists simply assume recessions don't exist, that they can't exist, that there are no idle resources, no involuntary unemployment. Since everything is already optimal and in equilibrium, the economy is a zero sum game and any attempt at change can only make things worse. Because of this no stimulus is even possible as it can only redirect resources from their current use to the use of government. There is even a bit of truth in this during normal times when the economy actually is operating at capacity. There is no cure for recessions because they are figments of our imagination. It certainly saves a lot of work trying to predict, explain, and remedy them. In this bizarro world, there is no output gap, empty homes and idle factories are just speculations for higher future prices and the unemployed are just enjoying leisure. Putting more people to work is just denying them their leisure and recessions are just long awaited and much desired vacations. If you believe this, not only is fiscal stimulus impossible, even monetary policy is unnecessary so one has to ask them why it should be pursued. One can only imagine what other innovations they might suggest, an end to unemployment and welfare, balanced budgets, and the rest of liquidationist policies.

Now over the long haul stimulus would not be stimulative because the economy would be operating near capacity and it would just redirect otherwise occupied resources within the economy, possibly to less desirable ends. But the same is not true in the short term if there are idle resources. In fact, if Ricardian equivalence holds there is little reason to expect people have not already taken these government stimulus actions into account in their planning from the start and have planned for the government to do just this for them in a situation like this. Call this the Hyper-Ricardian Hypothesis. In that case to not do it would be disappointing expectations that had been previously established.  Far from people countering fiscal action to make it ineffective, they will have planned for it and be relying on it to smooth their consumption.  Lack of stimulus could mean they may not be able to.