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.