Rational Expectations in a Recession

Paul Krugman wrote a (bit self-serving) post about the differences of viewpoints between the "saltwater" and "freshwater" economists in the US.

In this article there is one bit of economic orthodoxy that I don't quite get:

Think about the story of unemployment I’ve just described. It’s a story in which a contraction in the money supply can produce a recession – but only as long as people don’t know that there’s a recession! You see, if people do know that there’s a recession, they know that the low prices they’re being offered reflect low overall demand, not specifically low demand for their products.

I'd say that en expectation of a smooth change in the overall price level in a recession is certainly not what anybody would expect in a recession.

When the general population hears the word "recession" they think of an economic disturbance. This disturbance manifests itself as a shock-wave. In this wave, most of the people quite rationally anticipate a possible loss of income, which can be passed on to expenses only with a considerable delay.

This anticipation causes people to cut down on spending, which just reinforces the initial drop in demand. It's the prisoner's dilemma with millions of participants. Betting against the shock-wave would not be too rational.

This phenomenon is not that different from a "traffic wave" that can bring a whole highway to a complete standstill even if there is no apparent reason whatsoever. However, it is quite rational to expect congestion in dense traffic, because it happens.

These kinds of issues make the economic models that assume perfection for human beings quite dangerous. As can be seen in the video of traffic waves below, even small human errors accumulate to drastic disturbances in a tightly coupled system.



To mitigate these problems, "shock-absorbers" should be built into the economy. These absorbers would eat some of the efficiency of the system. On the other hand, so do shock absorbers in vehicle suspension, if the focus is on the short term. (Shock absorbers actually do increase the initial impact of a pothole.) We really have to reach a better trade-off between efficiency and reliability in the financial system.

These economic shock absorbers could take the form of increased transaction costs, or possibly taxation of capital gains that would discourage short-term gains.

The Estonian Laboratory of "Free" Market Economics

Ambrose Evans-Pritchard of Telegraph.co.uk writes an opinion piece about the "debt deflation laboratory" of the Baltics. His writing is thoroughly one-sided, as usual, but he has some valid points.

Professor Ülo Ennuste from Tallinn University says the private net wealth of Estonia's people has fallen below zero. I know of no other country in the world where this has occurred, though Latvia may be deeper in hock. Estonia's foreign debt is 116pc of GDP, second highest in Eastern Europe.

It is not a good moment for the poster-child of the flat-tax revolution, but those crowing the end of "Margaret Thatcher's Baltic Model" neglect half the story. Estonia's euro peg is anything but free-market. It makes Tallinn dance, awkwardly, to Frankfurt's distant tune. It stoked the boom by enticing people to borrow cheap at eurozone rates: it is now prolonging the bust.

[...]

The government could spend more. The national debt is just 5pc of GDP. It chooses not to do so. Such ultra-orthodoxy shows admirable discipline. Estonians will be a shining example to us all if they pull it off – and hold their society together.

Prof. Ennuste has some dubious figures. It's hard to believe that Estonian private assets would be worth less than 116% of GDP. There are other inaccuracies in the article as well.

However, the criticism against the Baltic currency peg policies is perfectly reasonable. Deflation (or "internal devaluation", as the euphemism goes) brings undeserved short term gains to those who are in cash assets. It will also encourage liquidation of real capital in a scramble to cash.

Keeping the currency pegged while maintaining completely disparate interest rates made absolutely no sense from the start. It was a source of "free money" to anyone who borrowed in Euros and invested in local currencies. Unfortunately, there's no such thing as a free lunch and never will. This "free money" virtually guaranteed a foreign currency denominated credit bubble.

The Euro is the wrong point of fixation. After all, the Euro has no inherent value of its own at all. The only meaningful measure of the value of a currency is against real goods and assets.

It might be absolutely impossible to avoid a degree of deflation after a humongous credit-fueled asset bubble, but at least one shouldn't be aggravating it, unless the objective is a massive overshoot in the downside.

A commenter "John" strongly disagrees with the opinions of Evans-Pritchard:

Estonia won't benefit from a devaluation, it will merely create instantaneous inflation, because the country is so small and so intertwined with neighboring economies.

Inflationary policy is exactly what Estonia needs right now, as it is headed for a deflationary spiral that will not stop before a serious overshoot. If currency reserves are not exhausted, the deflation will eventually come to a stop when foreign money comes in for hunting bargains. At that point the Estonian people might truly have lost their net wealth. They will be forced to sell their crown jewels just to survive.

"John" continues:

Instead a devaluation would destroy the last beacon of stability, the protection of value that the currency offers.

Currency is of no inherent value whatsoever, only real investments are. In the short term, the currency may look like a means to preserving wealth. However, this doesn't mean that people in aggregate are maintaining their wealth.

Even though the "value" of the currency is steady, or even grows in comparison to real goods, the quantity of currency shrinks through deleveraging. The grand total is actually shrinking. This reflects the real value that is destroyed through liquidation.

To all those who like comparisons to Zimbabwe: The Baltic policy is the mirror image of the Zimbabwean policy. In both cases the central bank and government is aggravating an already adverse trend. Hyper-deflation is not much nicer than hyper-inflation.

The Baltic states truly are a laboratory for the Chicago school of economics, with flat taxes, efficient market theories and all. I feel sorry for the human guinea pigs of the Baltic states.

Financial Engineering, Gambling and Deflation

TomDispatch.com has a nice summary of the gambling associated with structured finance, written by Barbara Garson. She has been searching for unemployed people that were handling those structured financial products, especially credit default swaps, that seemingly brought the whole world down. She was absolutely unable to find such people, even from Lehman Brothers or AIG. (Note to Garson: These people like to call themselves financial engineers.)

At the last paragraph Ms. Garson reviews the situation from the point of view of the real economy, where productive people are kicked out of jobs, while financial engineers keep on pushing their wares.

In other words, people are speculating on derivatives and derivatives of derivatives because there's no action in the real world. You can't invest in new real businesses or lend money to old real businesses for expansion unless people can afford to buy the products they'll produce. That brings me back to where I started: our real world. You know, the one where just about everyone's unemployed except those swap guys.

In a deflationary environment, real assets, like factories, start to look like huge risks. To keep investors from withdrawing from the real economy, financial assests need to be equally scary to investors. Governmental bailouts of financial assets simply encourage people to withdraw their capital from the real economy to plunk it into government-guaranteed gambling.

Safe financial assets, like cash and government securities, that have no backing in the real world, need to be scary as well. To achieve this, some inflation expectations are required. The Federal Reserve has been quite aggressive on this front, and clearly quite successful. Unfortunately, the European Central Bank does not seem to take this thankless task quite seriously.

Even if holding cash could be turned into a scary proposition, there are ways to store value that, even though physical, are equally as useless to the real economy. With this I naturally mean precious metals. Naturally some of the "real" economic activity has not much value either. Activity with negative value is quite possible. (Let's call it the salad shooter economy, in honor of James Howard Kunstler.)

All this trouble was brought to us by a financial market that grew to be bigger than the real economy. The solution to our problems should not necessarily proceed by making the real economy even smaller. That route will only result in a self-reinforcing deflationary spiral. Instead, the real economy should be functioning, while the financial economy should deleverage and shrink. A complete government bailout of the speculative financial system will achieve the exact opposite.

Let gamblers take their losses. That alone will give a boost to the attractiveness of the real economy. There's a problem with that proposition: all of us with savings at financial institutions are part of the gamblers through our funding of it. But as we have all gambled, we must all bear the losses.

Even though deflation is the immediate issue, as credit is collapsing, ultimately existing savings that are invested in credit will lose some value, because of the eroding base of credit worthy debtors on which its value was based. This loss of value can happen through a process of default, through being diluted by new savings, or through a devastation of the real economy.

The third option initially involves massive deflation, which might make it attractive to those that hold cash assets. However, it will ultimately result in people with cash assets facing empty store-shelves, at which point the deflation will suddenly turn into massive inflation, quite similar to the receding shoreline before a tsunami.

We have to remember that inflation has both a numerator and a denominator. In this situation, increasing the numerator (in the dilution scenario) is much preferable to a collapse of the denominator. Unfortunately, this might already be somewhat too late. If the collapse advances from industrial production to food production, there will be real trouble.

Paradox of Thrift, Savings and Investment

There was such a great comment by reader "es" on a post about the paradox of thrift at Paul Krugman's blog that I just have to copy it here verbatim.

Krugman:

The story behind the paradox of thrift goes like this. Suppose a large group of people decides to save more. You might think that this would necessarily mean a rise in national savings. But if falling consumption causes the economy to fall into a recession, incomes will fall, and so will savings, other things equal. This induced fall in savings can largely or completely offset the initial rise.

Which way it goes depends on what happens to investment, since savings are always equal to investment. If the central bank can cut interest rates, investment and hence savings may rise. But if the central bank can’t cut rates — say, because they’re already zero — investment is likely to fall, not rise, because of lower capacity utilization. And this means that GDP and hence incomes have to fall so much that when people try to save more, the nation actually ends up saving less.

"es":

Okay, I admit I don’t really understand this. I always seem to get hung up on S = I (Savings equals Investment). What would happen if you worked from the hypothesis that S = I + W, with W standing for Waste? Sure it muddies things, because it’s hard to weight whatever you are measuring as to its true productivity. But this is reality. When the old paradigm doesn’t work, or leads to paradox, you have to question your basic assumptions. Not all savings lead to purposeful investment. Witness the proverbial gold under the mattress. Witness wheat put by for a bad harvest and then mouldering in a badly maintained storage facility. Check out the over-elaborate plastic toys that over-stimulate and maybe poison our already hyper-active children. Especially pertinent, witness a population underfed and under educated and inadequately protected from disease to guard against the future possibility of debt.

Already in your columns I see you speaking of saving and investment as different entities, and then when you get “wonkish” (I guess you mean mathematical) you fall back to S = I.

I recommend that you assign a graduate student to work on the need to incorporate more variables into the S=I axiom. It might get him a Nobel prize, or save the world, or something.

I just love the snark in that last paragraph.

Of course, the identity of savings and investment doesn't make any common sense, but since when such a thing has been expected of economic theory?

I'm not sure either if it makes any sense to think of this identity in terms of any units of currency, but in addition to the waste term on the right, there should at least be a term for credit expansion on the left. I would also amend the equation to

S + C = I + W,

where C is the net amount of credit creation. Of course this equation is not a real equation. There are severe time lags in all the processes that are part of it. It can only be discussed in a statistical sense:

E[S + C] = E[I + W],

where E denotes the expected value. In addition to a temporal sense for this statistical dependence, one must also think about the ensemble statistics to account for people with different concepts for value, etc.

Credit has the ability to create investment without any net savings. Somebody gets into debt, which is equivalent to negative saving. Somebody else gets the loaned sum of money, and decides to save it. The net savings are zero.

However, there would have possibly been an investment that was made with the borrowed money. All is well, as long as the debtor pays the money back. Credit is a form of delayed savings. Investment is made first, then come the savings, little by little.

Problems occur when too much credit is extended. What if there is no income from which to save? People default on their loans. Oops... Now (nominal) investment has been much higher that the "savings" from which it was supposedly made. Savings are actually smaller than investment.

This is where the identity asserts itself with a lag. The value of savings increases while the value of investment decreases. Result: deflation.

More on the TED AR Embarrasment

Chris Anderson of ted.com in Twitter about the Chris Hughes augmented reality talk scandal:

@UnitZeroOne Chris Hughes agrees we shd take down the current version of his talk. See my comment: http://tr.im/puT5 & thanks.
about 1 hour ago from web in reply to UnitZeroOne

At 1:59, this might be the shortest ever #TED talk. Augmented reality in a browser. It's a wow. http://on.ted.com/1A
about 6 hours ago from web

From "wow" to take-down in 5 hours. Amazing.

Ugly AR Ripoff at TED.com

I am completely dumbfounded. Hacker Chris Hughes made a very short presentation of Flash-based augmented reality in TED2009 without mentioning the open source projects (FLARToolkit and Papervision3D) that his very basic demo is almost completely based upon. In addition, he made remarks that let the audience understand that he had a major role in the development. Read more of the issue at UNITZEROONE.

Could it really have been true that the moderators of TED were so completely unaware of the state of the art in augmented reality? This presentation was a big failure on the part of the TED2009 organizers.

I don't think Chris's response quite cuts it. He should really apologize instead of making lame excuses about the "fear and frenzy" of speaking at a TED conference. On the other hand, I kind of feel sorry for the guy. Having made his appearance at TED practically an obsession, it surely does not feel good for him to come out of it looking so awfully bad.

Anti-Keynesian Insanity in Latvia

Has the Latvian government gone mad? Sacrificing the whole economy of the country to maintain a currency peg is insane. It will most probably result in a devaluation later anyway, with much less results than an earlier devaluation.

It is a question of fairness. The only party that gains an advantage from the currency peg are those with Lat-denominated paper assets. It doesn't make much sense either, because the kind of deflation that is required for keeping up the peg will result in the paper assets being defaulted upon anyway, except for the government paper.

Devaluation will not prevent the problems that were created by excess credit, but it is an important tool in preventing a deflationary spiral.

Robert Anderson and Stefan Wagstyl wrote in the Financial Times about Latvia's conundrum:

With the backing of the International Monetary Fund and the European Union, Riga is hoping that if it can impose enough pain on the domestic economy, it will be able to maintain its exchange rate peg to the euro. That would allow it entry into the single currency zone within the next four years.

After months of dithering, the government last week put together a package of measures that will mean Ms Blumberga – who earns just 280 lats ($552, £337, €398) a month – along with hundreds of thousands of other public sector workers will suffer a 20 per cent pay cut. Even pensioners will see reductions of 10 per cent.

This is just insane. A crash in domestic demand is the only thing that is sure to follow from such moves. There is a very high risk of starting a deflationary spiral.

Landmark property developments such as the twin Panorama Plaza towers on the road between Riga and the airport stand all but empty and shopping malls look forlorn. House prices fell by one-third last year, insolvencies are up and banks are repossessing more mortgaged properties and leased cars. “Business is in hibernation,” says Gunnar Ljungdahl, who chairs the Swedish chamber of commerce in Riga.

How exactly is intentional deflation going to help in this situation? When wages are drastically cut, we can safely wait for even more insolvencies and repossessions. Shopping malls are a dead investment when the purchasing power of the population rapidly shrinks.

In these circumstances, many governments devalue to spread some of the costs to foreign creditors and to boost the economy by making exports – which include wood products – more competitive. IMF officials have indicated that the organisation was divided over the wisdom of defending the lat’s peg but was finally persuaded by pressure from Riga’s EU partners as well as the Latvian government’s own refusal to contemplate devaluation.

So it's actually other EU countries that Latvians can thank for this disastrous policy. I thought the EU was supposed to be a project of peace. Killing a member country to "protect" irresponsible creditors at other member countries is a recipe for serious conflict.

Latvia sees the currency peg as the linchpin of its economic policies. It helped drive down inflation and is the route to euro entry. Latvia’s governments have often been weak but have always defended the peg and supported the powerful central bank, where both the prime minister and finance minister used to serve. “For Latvia the peg is the last pillar of trust,” says Henrik Hololei, an Estonian cabinet head at the European Commission.

All hail The Peg!

Also, Latvian officials argue that in a small economy, where 60 per cent of export value is in imported content, devaluation will not do much except encourage inflation. With some 90 per cent of all loans in euros, they add, it could bankrupt tens of thousands of companies and individuals. But the price of avoiding devaluation will be huge economic, social and political strains. Valdis Dombrovskis, prime minister, admits his main challenge now is “to preserve the social peace”.

"Encouraging inflation" (or discouraging deflation) is exactly what is needed at the threat of a deflationary spiral. Instead, Latvian officials are ready to give the economy a good kick to the backside. The foreign loans that turn out to be unaffordable will be defaulted upon one way or the other. If the income of debtors shrinks the effect is exactly the same. And a defaulted loan in euros is no bigger loss to the creditors, whatever the exchange rate.

So, as there is a wave of defaults anyway, why should there be a wave of deflation as an insult added to the injury. Deflation is an unjust reward of those who hold paper assets, and a punishment for those who hold actual assets.