Bubbles, Unemployment and Fiscal Stimulus

Paul Krugman, is trying to fight for the usefulness of fiscal stimulus in mitigating unemployment.

Ryan Avent has some fairly harsh words for Arnold Kling’s recalculation theory of business cycles. Tyler Cowen, predictably, thinks Ryan is too snide.

But what none of the participants in the debate seem to realize is that Arnold is basically reinventing 1934 macroeconomics.

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It’s all there: mass unemployment is necessary, because you have to shift resources away from sectors that got too big, stimulus is a bad thing because it slows the necessary adjustment. And now as then, the whole notion falls apart when you ask why, say, a housing boom — which requires shifting resources into housing — doesn’t produce the same kind of unemployment as a housing bust that shifts resources out of housing.

Both booms and busts involve shifting of resources between sectors. This much is self evident. It would be stupid to try to deny that. This doesn't mean that the unemployment should not be alleviated at all.

Krugman unfortunately makes a complete fool of himself in the last paragraph. Of course booms don't involve unemployment. In a boom, the driving force of inter-sectoral adjustment is a surge in demand. In a bust, the cause is a collapse of demand.

In a boom, the workforce moves behind the pull of opportunity. This was clearly visible in the flow of newly minted real estate brokers who were encouraged to leave their prior jobs in search of bubble-induced income. In a bust, the realignment is caused by a push-type phenomenon. (Or is it a kick?)

This is such an elementary thing that I can only wonder what Mr. Krugman has been smoking while writing that last paragraph.

To clarify, my own view is that increasing unemployment can hardly be completely avoided in a major bust of a bubble, but that government projects can (and should) be brought forward to mitigate it, if only to make use of the suddenly cheap labor and raw materials. Busts clearly have effects on people who were not directly involved in the bubble and an uncontrolled collapse is bad for everybody.

Equally, I believe that fiscal measures might even be appropriate in controlling the growth of a bubble. Additional small taxes on house-flippers (say for houses bought and sold within 12 months) could have helped slow down the development of the housing bubble. Additionally, it could have provided a larger cushion for the inevitable fiscal collapse.

In both ends of the boom-bust cycle, monetary policy should be the primary means ahead of fiscal measures. In this sense, the QE policies should go even further, as there is a lot of credit that is (and should be) paid down.

This collapsing credit can be replaced with base money even if the money multiplier has collapsed to unity. Instead of "mopping up the liquiduidity", central banks should bring back meaningful cash reserve requirements (to all bank-like entities) after the economy has recovered from the excess of credit. This would naturally will be fought against tooth and nail by the financial sector.

The Bubbles Are Piling Up

It seems that a Kazakh bank might be the first one to collapse from losses that originated in the commodity bubble.

New York Times: The largest bank in the Central Asian nation of Kazakhstan, whose economy soared when oil prices were high, announced on Friday that it could no longer repay $11 billion in foreign debt.

The bank, BTA, said it would pay only interest to foreign creditors, who lavished the country with loans during the commodity boom. The move underscored the growing financial instability in countries all across the former Soviet Union.

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BTA had been wobbly for some time. The Kazakh government partly nationalized the bank in February. That was taken as a sign that the bank’s debt might be covered by a sovereign guarantee, though even at the time government-appointed executives said they were studying ways to restructure foreign debt.

I have long been suspecting that the dangers of letting large banks fail have been much exaggerated, especially compared to the burden that is caused by governments picking up the tab. Hopefully the economy of Kazakhstan will not completely collapse.

The losses from the housing market and structured credit bubbles haven't been cleared. Yet we are already witnessing huge losses from the commodity bubble.

Since the 60's the US has seen an ever more rapid sequence of bubbles: conglomerates, junk bonds, real estate, tech stocks, housing, structured credit, commodities, and finally, government bonds. When the accumulation of foreign dollar reserves reverses itself, the government bond bubble will come to an end. That might actually be pretty close now.

It seems that the era of serial bubbles is ending in bubbles that are ever more short in duration, until they can no longer be “fixed” by creating a new one.

When looking at the whole trend, I can't help but to think that the biggest bubble of all has been of the standards of living in the developed world. Western standards of living were raised to unsustainable levels by relying on undercompensated use of colonial resources, until the 1960's. After the colonial period, a massive accumulation of debt has been used to delay the inevitable balancing of global consumption patterns. All the other bubbles are just minor manifestations of this all-enclosing bubble of debt.

US Financial Sector Debt = Way Overboard

Financial Times columnist Martin Wolf presented a graph of US private sector debt in his column from last Tuesday:



The growth of financial sector debt is simply amazing, and reflects the absolutely out-sized growth of the financial sector compared to the real value-generating businesses. One has to note that this graph is relative to the size of the GDP and ultimately susceptible for mean-reversion.

As one can see from the figures, business and household debt has been reasonably stable, at least until the end of the techno-bubble around 2000, but the indebtedness of the financial sector has just been growing since at least 1976. It is quite incomprehensible that the financial sector has more debt than all other business sectors combined. It is quite clear that this situation has not been in any way sustainable for at least 10 years.

Do We Really Need More Credit?

Eric Dash and Vikas Bajaj write in the New York Times under a headline: "In 2009, Economy Will Depend on Unlocking Credit."

How long this situation lasts will determine the immediate course of the nation’s economic life. Will the recession, already a year old, drag on through 2009 — or even longer? Will the stock market revive soon or shrivel further? What of the beleaguered housing market?

The answers to those questions will depend on the availability of credit in all its forms — home mortgages, personal and business loans and bonds sold by corporations, states and municipalities. For now, many banks are hoarding money rather than lending it. Their holdings of cash have nearly tripled to just over $1 trillion in the last three months, according to Federal Reserve data.

This is complete rubbish. There is clearly too much debt in existence. The current economic trouble is greatly magnified by the fact that each piece of actual money is lent about ten times in a ridiculous daisy chain of debt. This creates a situation pretty much analogous to a line of cars driving at a high speed on a highway with too little space in-between. Everything seems to run very smoothly until any small obstacle results in a massive pile-up.

What is now needed is some controlled creation of actual money. The problem is that the money that is created by a central bank is traditionally given to banks, which have absolutely no use for it at the moment. This is not a liquidity crisis, like the authors try to claim above. Liquidity is about trust, but insolvency is a fact. It is fully natural for the banks to keep their lending down, because of the shortage of solvent debtors.

Instead of force-feeding cash to banks, we need to have a source of money to the actual (nonfinancial) economy. Because paying back debts with existing deposits is deflationary—the deposits used for debt payment just cease to exist—money from outside the banking system will be needed for reducing the economy-wide debt load.

At the moment, people collectively owe much more money to financial institutions that they have in deposits. This is a debt trap that can not be escaped without an influx of money from outside of the financial system.

There should be a period of government spending with newly created money directly into the economy, accompanied by rising reserve requirements to prevent the banks from multiplying that cash into new debts. We should be aiming at returning reserve requirements to healthy levels around 25–50%, where each piece of actual cash could only be lent out once or twice.

The real (nonfinancial) economy would use the seignority of newly created money to escape from the clutches of the overgrown monster that the banking system has become. Paying existing debts with new money would create permanent deposits, instead of the "temporary" deposits that are borrowed into existence.

The inflationary effects of monetary printing would not necessarily be very high, if the printing is kept below the rate of credit destruction. That would not be a very difficult thing at the moment. Of course, some people that have been accumulating savings in anticipation of deflation would not get those expected gains, but the alternative of complete collapse would be even worse. Besides, those savings—even if they are stuffed into mattresses—are ultimately made of funny money like everything else.

So my point of view in short: In the long run, economy will depend on demolishing debt.

Debt as a Source of Short-Sightedness

As an addendum to the previous post, there is a reason for the increasing short-sightedness of businesses.

Shortening of the time scale of business decisions is a direct result from the overall increase in the level of gearing. When equity decreases in size compared to the overall level of debt in a company, the time scale is inevitably compressed. This is because creditors, unlike equity investors, are not willing to wait for profits. Interest must be paid on the debt at a predetermined rate, or a default is triggered. When the overall level of debt increases, time scales shorten and risk-aversion increases.

Below is a graph of the average rate of growth of credit/debt versus GDP in various industrial nations:


Here is the same thing as a graph over time:


There is no reason to assume that this statistic would not revert to a mean over time. Such relative measures can not keep developing in one direction forever. What is noteworthy, besides the huge level of the debt, is its remarkably monotonic growth. The developed world has not seen a real reduction in debt for over 30 years. Now we are finding out how painful that actually is.

Normal Level of Lending?

A quote from a Bloomberg article about the ongoing discussions in the US Congress:

Federal Reserve Chairman Ben S. Bernanke told lawmakers at the hearing that using the TARP for buying stakes in banks is ``critical for restoring confidence and promoting the return of credit markets to more normal functioning.'' He warned that lending in the U.S. is ``still far from normal.''

Quite true, Chairman Bernanke. Lending is far from normal in the US. It has only just started to come down to normal levels after 30 years of excess.

An honest analysis would discuss ways of slowing down the return to norm. Even more important would be measures that would help people and businesses to adjust to smaller levels of lending and debt.

Cyclic History in Action

Finance professionals have had quite a negative attitudes to talk of paralles between the current situation and that prior to the Great Depression of the 1930's. Now that such comparisons are starting to appear in many mainstream publications, Scott Reynolds Nelson, a professor of history, in a guest post in iTulip.com, makes a claim that the 1930's depression is not the correct parallel with the current situation. Instead he makes direct parallels with the Real Great Depression that started with the panic of 1873. (Hat tip to Tim of The Mess That Greenspan Made)

When commentators invoke 1929, I am dubious. According to most historians and economists, that depression had more to do with overlarge factory inventories, a stock-market crash, and Germany's inability to pay back war debts, which then led to continuing strain on British gold reserves. None of those factors is really an issue now. Contemporary industries have very sensitive controls for trimming production as consumption declines; our current stock-market dip followed bank problems that emerged more than a year ago; and there are no serious international problems with gold reserves, simply because banks no longer peg their lending to them.

In fact, the current economic woes look a lot like what my 96-year-old grandmother still calls "the real Great Depression." She pinched pennies in the 1930s, but she says that times were not nearly so bad as the depression her grandparents went through. That crash came in 1873 and lasted more than four years. It looks much more like our current crisis.

He also provides a nice lithograph from 1875 that shows the get-rich-quick attitude of the time as people chasing bubbles that are blown by a devil-looking character. I have reproduced the lithograph here in a less compressed format from the US Library of Congress.



He also draws analogies to the global imbalances caused by unequal cost factors across the global marketplace.

Wheat exporters from Russia and Central Europe faced a new international competitor who drastically undersold them. The 19th-century version of containers manufactured in China and bound for Wal-Mart consisted of produce from farmers in the American Midwest. They used grain elevators, conveyer belts, and massive steam ships to export train loads of wheat to abroad.

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The echoes of the past in the current problems with residential mortgages trouble me. Loans after about 2001 were issued to first-time home buyers who signed up for adjustable rate mortgages they could likely never pay off, even in the best of times. Real-estate speculators, hoping to flip properties, overextended themselves, assuming that home prices would keep climbing. [...] As in 1873, a complex financial pyramid rested on a pinhead. Banks are hoarding cash. Banks that hoard cash do not make short-term loans. Businesses large and small now face a potential dearth of short-term credit to buy raw materials, ship their products, and keep goods on shelves.

Wow. I hope that he is not proven right in this assessment.