Wednesday, May 20, 2009
As To Yesterday's Question
The credit crisis began in 2007, but various liquidity measures prevented credit problems, as such, from directly impacting the real economy.
The responses were very good, although some of you were thinking about the future rather than the recent past. My point is that we need to be accurate about the recent past before developing future policies, and this is the critical gap I saw in Prof. Brock's explanation of what had occurred:
First, what exactly caused the worst credit crunch the nation has arguably experienced since the depression of the 1930s? Second, how did the downturn in the US morph into a collapse in Planet Earth's GDP rate from nearly 5% in June 2008 to -0.5% in winter 2009? Third, can traditional macroeconomic policy suffice to turn around the economy? More specifically, will a killer application of classical fiscal and monetary policy truly restore the economy to a stable growth trajectory? Or is there an internal contradiction within macroeconomic policy that could prevent it from succeeding this time around?See, central banks aren't everything. Central banks (and especially the massive extension of dollar credit facilities led by the Fed) did do a great deal to keep the collapse in interbank lending, which really occurred in 2007, from causing further drastic problems. That is why we didn't see the break in economic growth until about 12 months later.
To explain the "perfect storm" in the credit market, we drew extensively on the new Stanford theory of endogenous risk to demonstrate that there are three jointly necessary and sufficient conditions to predict and explain the perfect storm we have experienced: (i) A mistaken market forecast of some exogenous event that impacts security prices (in this case, a vastly higher than expected default rate on mortgages); (ii) A high level of Pricing Model Uncertainty bedeviling bank assets (the true cause of the "toxicity" of those complex securities that have clogged the arteries of the banking sector); and (iii) An unprecedentedly high degree of leverage in the financial sector (money center banks had off-and-on balance sheet leverage of about 40:1 in contrast to the socially optimal leverage of 10:1). The reader can tack "greed" and "incompetence" onto this triad, although doing so diverts attention from the real causes of today's crisis.
To explain the collapse of economic growth worldwide in an astonishingly short period, we utilized a game theory model that explained how the cessation of inter-bank lending amongst the principal money center banks of the world precipitated the first known case of global credit market emphysema: The availability of credit dried up almost everywhere in the course of six months, from Auckland to Iceland. We stressed that this credit contraction had little to do with "globalization" as properly understood, and had no counter-part in history.
What broke the global economy was the rise in energy prices. That rise made quite a bit of trade unaffordable and massively increased the need for credit lines for exports and working capital. Ocean transport costs more than doubled over less than 8 months for quite a few routes.
So I disagree with the second bolded statement above, although I think the analysis and discussion of policy measures on the whole has merit.
Now the rise of oil prices was speculative in nature, and clearly not founded in an accurate assessment of the prices that the global economy could then absorb. The proof is that the global economy seized up and then imploded. To my mind, this procession of events also raises another very important question:
Did the massive flood of liquidity injected by central banks in an attempt to defuse the impacts of the interbank lending crisis end up causing some of the speculative run-up for oil and other commodities?
My guess is that it did. Maintaining the flow of money, in the absence of other investment vehicles, appears to have provided the fodder for a speculative party launched partly in the attempt to defray losses on the bad securities. It also may have funded the party of the shorts, which led to the suspension of short trading on major exchanges around the world.
Note that if I am correct, then some of our current problem was caused by liquidity and governmental response.
I would argue that the Chinese are now reproducing a similar trajectory with some of their policies. The massive flood of bank lending and the authorization of margin trading on their exchanges sure seem to me to have produced some bubble-types of trading. I'm not the only one who's noticed. If I'm right, the problems will start showing up in 2010 for the Chinese.
More on this later, especially your comments. I'm running ragged today.
Governmental liquidity injections to ameliorate the LTCM/Asian currency crisis (plus a flight to relative safety) poured money into the U.S. stock market, and caused a bubble in tech stocks, which blew up in 2000.
Governmental liquidity injections to ameliorate the bursting tech bubble (plus a flight to relative safety) poured money into U.S. housing and energy/commodities, causing a bubble which blew up in 2008.
Governmental liquidity injections (plus a flight to relative safety) poured money into U.S. government obligations, causing a bubble in government spending, which blew up in....
Energy prices rose because as Neil says, liquidity was injected. That makes adding liquidity the cause.
Energy prices also rose because of the massive growth in China due to our policy of shipping them our money through a massive trade deficit.
Unfortunately, neither adding liquidity nor sending China our money is going to provide Americans with more jobs long-term.
Without jobs, the government will no doubt add even more liquidity as an attempt to keep things propped up. Adding even more liquidity will no doubt boost the price of energy, probably to the point we have a double-dip recession, and a triple-dip, and so on.
Round and round we go, in a never ending game of chicken and the egg. Which came first? Perhaps it isn't all that important.
Here's what seems very important though, at least to me.
I've been a chicken since 2004. Being a chicken has really helped protect my nest egg so far. What's going to happen if and when we are all chickens trying to protect our nest eggs though? I cringe at the thought.
The government knows. I think that's why it decided to lower the annual cap on inflation protected tax deferred I-Bonds from $30k to $5k recently. It still plans to honor them clearly (or it wouldn't have bothered with the change), but it no longer hands them out like candy. It's pretty amazing when you think that they also lowered the rates to the point you'd think nobody would even want them anyway.
0.1% over inflation? Does that sound like something that's such a good deal that it needs to be limited? After taxes, that's pretty much guaranteed to lose money. I cringe at the thought that it still might end up being a good deal in hindsight (relative to other investments). I'm reminded of the 1970s. I'm also reminded that many economists think a seriously negative interest rate environment will solve our current problems.
I'm not at all convinced that a currency crisis will solve our current problems, especially if we think that the price of oil was the straw that broke the camel's back.
This has slowly eroded global purchasing power - the result is high household debt in many countries that are strong consumers. Needless to say, over time this will produce a fall in consumption.
The ultimate cure will be for the production staff in these countries to get improved lifestyles sufficient to consume more of what they produce, or for production to shift back enough to the consuming countries to enable those countries to consume more without running up debt, or more likely, a combination of both.
A government does not need to throw in liquidity - a government can just let the lifestyles stabilize on their own.
Of course, in countries like the UK and the US, governments have tended to foster the overachieving borrower and are now a part of the problem themselves.
Also, I should not be so glib about the government debt bubble--maybe I'm wrong this time. Maybe it can go on for decades. Maybe Washington can bleed the country white, and lavish the proceeds on itself and a few favored localities (California, Chicago, and New York City, most likely). Maybe the correct thing for me to do is pick up and move the family to Chicago--there's jobs there for me.
Or maybe it's just another bubble that will pop within five years.
I agree. It's one more example of how income inequality can hurt the global economy, not that those on the highest end of the pay scale have any financial motivation to do anything about it.
What's going to happen in the distant future if the average worker is actually paid nothing? It might seem far-fetched, and perhaps it is. However, I do think that thought every time I scan and bag my own groceries at QFC.
As a side note, my word verification is "paing". I'm feeling it!
Financial innovation is still with us as economic growth on the scale necessary to serve the lifestyle Americans dreams can no longer be generated with just cheap energy. Rather credit based on financial wealth illusion has become our economic foundation.
I like this too. I cannot understand why I can see this but so many in the government cannot. People in China and India are not rushing to buy things from America, especially since we don't produce that much here any more. Shifting the jobs to those countries just pushes everyone's lifestyle down to the same, just above poverty level. Not exactly what most of us want to see. I suspect that the American consumer has enough stuff (and there's plenty of stuff at garage sales for now, if we didn't stock up) to last for several years without new purchases. Can China hold out that long?
That, unfortunately, is dangerous protectionist twaddle, in my opinion.
The problem isn't that we import things from China. That should have been a good thing. The problem is that we haven't been replacing the outsourced production with higher-value production, or production in which we have a natural advantage.
If we banned all imports from China tomorrow, we would still not be able to increase the returns on labor to the laborer.
This (again, in my opinion), is because the U.S. government actively discourages capital investment to improve the productivity of labor. There are several ways in which it does this:
1) Double-taxation of dividends
2) Highest effective corporate tax rate in the world
3) Capital gains tax that is too high, on gains that are not indexed for inflation--this gradually destroys the existing capital stock.
4) Payroll taxes that discourage increasing the value of labor
5) Environmental permit processes that discourage the re-use of existing capital stock and new investment in productive capital
6) Wagner-act adversarial unionism, which prevents efficient use of existing capital with outmoded work rules
I'm sure it's possible to go on. The idea is that it's not China that is our problem--it's us. Americans can't make anything because the government won't let us, not because China took it away. China helped us cover up our deficiencies for a while, but if China disappeared tomorrow, we'd still be deficient.
Nobody forced China to take our jobs. We offered them.
I would also add...
If you mix a billion low paid jobs in with 300 million high paid jobs, you probably won't end up with 1.3 billion high paid jobs. Further, you won't end up with even average paid jobs. You might not even end up with weighted-average paid jobs (since there could easily be a worker glut).
Consider one of my favorite analogies.
If you add a cup of wine to a barrel of garbage, you end up with a barrel of garbage.
If you add a cup of garbage to a barrel of wine, you also end up with a barrel of garbage though.
Behold the power of garbage.
This analogy also applies to our entire banking system. Just think of subprime loans being garbage and it all makes sense. Once added to the system, the garbage could not be contained.
Drill NOW. Oil. Gas.
Get the NIMBYs out of the way.
Lower the world cost of oil.
Reduce the monies going to states that would gladly see us "humbled."
Reduce the leverage that Russia has over Europe by reducing the scarcity of fossil energy.
That's only true for garbage and wine. Adding more people, more ideas, and more productive capital to the world will raise everyone's standard of living. But you have to add ideas and capital at the same rate as the people. That's where the U.S. has fallen down.
I'd agree with that to a point.
Most ideas we do have seem centered on improving productivity though (i.e., reducing the need for future workers).
China Faces a Grad Glut After Boom at Colleges
"China is suffering from a higher-education equivalent of the global credit bubble. On government orders, China's universities -- most of which are state-controlled -- boosted enrollment by up to 30% a year, year after year for most of this decade, and built vast new campuses."
The Ph.D. Glut Revisited
"The Ph.D. glut has existed ever since the fall of 1969. The number of entry-level full-time professorial positions has remained stagnant."
I also want to clarify what I said. I never said people were garbage.
Wine: High Paying Jobs
Garbage: Low Paying Jobs
That's only true if productivity increases are limited to narrow applications by an exogenous force. For example, if the People's Toilet Paper Manufactory #37 is given capital budget to replace a 10 roll-per-minute machine with a 100 roll-per-minute machine, then perhaps 90% of the workforce can be let go, and go on the dole. No other jobs are available in the centrally-planned economy, because the government controls all capital investment, with an eye towards maintaining the existing level of production, rather than increasing the availability or quality of goods. So the workers go on the dole.
In an ideal free-market system, the increased productivity of ScottProcterKimberly TP Factory #37 releases workers to find something better to do with their valuable time than crank out toilet paper rolls. There's always somebody with an idea, and somebody else with spare investment capital to fund that idea, so getting a job is no problem.
I'm not saying we meet that ideal, but it's something to work towards.
I didn't mean to seem harsh in critiquing your garbage-and-wine analogy, but I did find it offensive. You do seem to be saying that no matter what I do to improve myself, my labor is less valuable simply because of the existence of somebody, somewhere, who makes less money than I do. I don't find it a very useful analogy. It may be that the value of my labor will end up equal to that of a Chinese worker, but if we do our part everyone's standard of living will be higher in the end.
The problem is that we aren't doing our part. Our government is limiting our access to productive capital, or worse, encouraging us to invest in unproductive capital.
In theory, what would happen if our ability to automate and outsource jobs exceeded our ability to think new jobs up? I think that's exactly where we are right now.
By the way, my girlfriend is unemployed. She's been working in human resources/benefits. It has become harder and harder to compete. First, colleges keep cranking out MBAs who will work for less. Second, human resources/benefits is something that can be outsourced (a previous job of hers was outsourced to Canada).
We've given a lot of thought about the jobs of the future. I'm relatively stumped. The goverment seems to think retail sales is #1 (in absolute numbers). I'll believe that when I see it. QFC recently strarted allowing customers to do their own bagging and scanning. In my opinion, we already have too many malls, strip malls, restaurants, auto dealerships, and so on. Internet shopping is also on the rise.
She's probably heading down the nursing path. There's a shortage and it's hard to automate and/or outsource. I cringe at how many other unemployed are thinking about it too though.
Further, nursing output can't be put in a container and shipped to China to help close our never ending trade deficit.
I would argue that globalization will improve the living standards of the average global worker. I'm not at all convinced it will help the living standards of the average American worker though. Real median wage growth here was struggling even when we had low unemployment.
I would also say that we had/have no choice though. Our long term future would be worse had we turned protectionist. That being said, I agree with you 100% that goverment is not helping our long-term situation. Capital should be flowing into productive endeavors, not propping up failures.
"I would argue that globalization will improve the living standards of the average global worker. I'm not at all convinced it will help the living standards of the average American worker though. Real median wage growth here was struggling even when we had low unemployment."
I agree, but my point is that that has very little to do with globalization per se. If anything, globalization has kept our standard of living higher than it would have been otherwise because the same effort brought us greater material payoff in the form of cheap Chinese goods. Globalization has probably postponed the day of reckoning by 20 years. Our problems go back at least as far as the 1960s, maybe as far as the 1930s. It's just that it takes a long time to burn up human and physical capital. We have to have a fiscal structure that rewards capital investment.
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