Credit Crunch Debate

Over at Marginal Revolution Alex and Tyler are engaged in an interesting discussion on the theory and empirics of the credit crunch.  I find Alex's arguments to be the more persuasive.  How about you?

Also, Anna Schwartz continues to provide important insights into this mess.  She has argued that unfortunately the Fed and the Treasury have acted as if the only lesson to be learned from the Great Depression is the lack of liquidity lesson, which she argues is not the relevant lesson.  She also used an interesting argument about how the attempt to recapitalize the banks is doomed to failure because we are trying to recapitalize insolvent banks, when only the solvent banks are the only institutions capable of using the funds correctly. This is similar to the arguments and data we found in relation to foreign aid --- only those countries that already had good institutions were the countries that could use foreign aid productively, countries where the institutions are bad, foreign aid just goes into a black hole.  But, of course, the countries with good institutions do not require foreign aid because they are already receiving foreign direct investment.  Schwartz's argument applied to the banks reinforces why the bailout and recapitalization policies we are following are counter-productive.  But they no doubt make politicians feel better because they are at least doing something, even if that something is the wrong thing to do!

Comments

[Bogdan Enache]

I agree with Anna Schwartz that this time there is no sign of monetary deflation and that the higher interest rates are a result of high uncertainty in the market - interest rates incorporate in fact an uncertainty premium because of the inability to asses the real value of the bad assets that various institutions hold (but also due to unknowns regarding what will be the political action). So, I think Alex Tabarock (and Robert Higgs) before him are right.

It's great that Anna Schwartz is against bailling out insolvent banks. However, in the WSJ interview - if I remeber correctly - he was against the Government buying shares in banks, but was in favour of TARP.

[Bogdan Enache]

Correction : "...SHE was against the Government buying shares in banks, but was in favour of TARP"

I don't know how exactly one can square the two positions : don't bail out banks, but socialize the losses from the falling mortgage assets by taking them off their balance sheet at inflated prices.

[Finja]

I just recently discovered Austrian Economics and found it the most persuasive economic school of thought. So I am only starting to read about it.

My question is a bit off-topic, but after reading those sentences

"This is similar to the arguments and data we found in relation to foreign aid --- only those countries that already had good institutions were the countries that could use foreign aid productively, countries where the institutions are bad, foreign aid just goes into a black hole. But, of course, the countries with good institutions do not require foreign aid because they are already receiving foreign direct investment."

I wondered what the Austrian view on foreign aid is? Could anyone provide me with some reading recommendations on this topic?

Thanks!

[Bogdan Enache]

Hallo Finja!

See David Osterfeld, Prosperity versus Planning: How Government Stiffles Economic Growth, chapter 6, entitled "Foreign Aid" (amazon.com has cheap copies, so I thing you won't be taxed for imports).

The argument is that aid provided by governments in rich countries to governments in poor countries drives out private foreign investement in those poorer countries, distorts local markets, promots bureaucracy, corruption and sometimes even finances dictators to opress their own people. Thus, foreign governmental aid basically doesn't improve much, if at all the life of the vast majority of people who live in poor countries. I know it sounds really unbelievable, but this might be what actually happens.

[Richard Ebeling]

Peter:

What these debates about whehter we are in a credit crunch or not; whether we are faced with a coming serious inflation or instead deflation; whether this wil be a "normal" recession or a coming real depression, etc., etc., -- what this should remind all of us of is Hayek's points about the pretense of knowledge, or what Wilhelm Roepke called the hubris of the intellectuals.

In fact, neither Austrian Economists nor our Neoclassical and Chicago and Rational Expectations "colleagues" know what is happening in the economy -- nor exactly how and why it hit right now or where the present "crisis" is taking us.

The "deadly sin" of hubris clearly has been greater with our economist colleagues. So using all available information (i.e., statistical patterns of past events) and inserting it in the "correct" model of how the macroeconomic "really" works . . .

Did Robert Lucus or Thomas Sargent know this was going to happen, when and why? Hmmmm. Or did I miss that op-ed piece of theirs in the WSJ? (Oh, they kept it as private, secret information so they could make a "killing" in the market -- now I know who the evil "short-sellers" have been.)

Bu more seriously Austrians have long insisted that the laws of economics are essentially logical relationships, not empirical ones; that economics can "predict" but only in qualitative terms, not quantitative ones; that economics can only make "pattern" predictions.

This economic crisismay I suggest, again reinforces the reality of the Austrian approach to social phenomena.

Austrians (true to their theory of the logic of the interconnections between credit expansion, market rates of interest, the term structure of investment, and relative price and allocation effects caused by the non-neutality of money) have often warned of the inflationary and destabilizing consequences from Fed policy over te last decade.

But no Austrian could (or did) claim to know when the cycle would turn, or what would set it off, and how the downturn would or could play itsef out, i.e., in what in historical retrospect we will see from the vantage point of some future moment as the actual patterns and also unique time-sequence of the "micro" steps by which this will play out.

We could not and cannot know these things. As Karl Popper pointed out in "The Poverty of Histoicism," knowledge of the future is logically impossible. If we live in a world in which knowledge changes, he said, then it is impossible to know tomorrow's knowledge today. Otherwise, it would be today's knowlodge and not a knowledge of the future, the details of which can only be known when the future comes.

We know how the Great Depression of the 1930s played out because it is now history. We know, for example, that FDR ran on a "conservative" platform of balancing the budget, cutting taxes, maintaining the gold standard, limiting Federal intrusiveness in state-level affairs, etc.

And we know that he did the exact opposite of these things when actually in office.

But instead of reading histories of the Great Depression, suppose we went into the archives of the newspapers of the time -- the "Wall Street Journal," the "New York Times" -- and, say, from 1929 to 1935 read the stories, day-by-day, the analysis and the commentaries and interpretations of what was happening and where it was leading.

I would suggest that virtually no one knew where the process was leading. Because it depended upon the "complex phenomena" of individual decisions, political policy choices, ideological influences, and everyday actions based on the expectations held at each moment in time.

And these intersecting actions and events generated the unique path-dependent process that we call the history of that time.

All of our analysis, expectations and predictions should be implicitly framed with the inescapable humiity of what our limited minds can know about the workings of our world.

Indeed, this is the reason we Austrians are always suspecious of political solutions to our social and economic problems. The working through the problem -- including an economy-wide econoic crisis -- requires more knowledge about the present and the future than any one mind or group of minds can master or ever possess.

So, are we suffering from "tight" or "easy" credit conditions? Has the stock market and housing market "bottomed out"? Will globalization be part of the solution to the problem, or will governments impose forms of trade restrictions to shore up domestic output and employment levels against foreign compeition? Will the next president actually be more concerned with "spreading the wealth" or letting the market adjust so the "pie" can keep growing (or growing faster than wrong-headed policy would allow)?

We will know all the answers -- when some future economic historian (maybe even an "Austrian") writes the history of our times, and tries to tell those future readers how it all happened and why.

Richard Ebeling

[Bob Murphy]

Dr. Ebeling,

I agree with the spirit of your post, and at times I've caught myself saying, "The Fed cut interest rates too much!" as if I know what they "should" be.

However, isn't it rather embarrassing that economists can't even agree on whether we should expect massive (price) inflation or deflation? Obviously I'm not saying that Human Action tells us CPI will increase 4.8% between now and 3q 2009. But what kind of "pattern prediction" can a Hayekian make, if not to be able to see (say) double-digit inflation three months before it happens?

[Carlos Novais]

What will happen in the future depends on what is happening now in the intervencionism side.

Sure, if the FED did not intervene (injecting a "junkie" out of trouble?) we could be 100% sure that massive systemic financial failures would ocurre with a colapse of the quantity of money and deflation of prices.

But as we know the present "regime" wil avoid that at all costs, so the expectation should be that all Central Banks wil inflate the reserves positions of the banking system which will translate to the creation of credit/money.

So, the game is like: what will be inflation taken granted that the intervencionism will inject X amount of reserves ant keep the interest rate at negative to inflation CPI.

Carlos Novais

[Richard Ebeling]

Dr. Murphy (Bob!)

Obviously, if we observe that the Fed goes on a money creating binge we would expect that "some time down the road" there may be signficant price effects.

But . . . the world (inspite of what some of our mainstream economist colleagues seem to suggest) is not a simple MV=PQ or Y=C+I+G.

For example, the debate over wht is happening in the financial market right now -- is there a credit crunch or not?

In the latest issue of "Forbes," Bob McTeer, former head of the Dallas Fed, has a column in which he interpretes the Fed's balance sheet and concludes that most of the apparent increase has in fact been "sterilized" at the same time through Fed selling of Treasury securities over most of the past year -- until now.

He says:

"In practice, however, the Federal Reserve over the past year has offset most of the increase in loans among its assets with decreases in its holdings of government securities. In other words, it has neutralized or sterilized the monetary impact of its lending--meaning the impact on bank reserves--with open market sales of government securities.

"The funds have gone to the borrowing banks, mostly through the new term auction facilities, but those funds haven't been net additions of reserves to the banking system as a whole. In an operational sense, the trading desk at the New York Fed has not set out to offset loans per se, but that is the effect of maintaining the FOMC's target Federal Funds rate. The targets have produced that outcome."

And McTeer goes on:

"If the purpose of monitoring the Fed's balance sheet is to gauge the expansionary or inflationary implications of its lending or other actions, a more appropriate way to do it is not to focus on growth total assets and liabilities, but to focus directly on bank reserves. Bank reserve deposits at the Fed, together with currency outside the banking system, make up what economists call the monetary base, or high-powered money.

"Rapid growth in the base (primarily bank reserves in practice) gives the banking system an ability to make more loans and investments and, hence, create more deposit money. The effective marginal reserve requirement is about 10%, so each dollar of new reserves will eventually add about $10 of money. Think of bank reserves as wholesale money and bank deposits as retail money. Exactly which bank deposits you include gives you different definitions of money: M1, M2, MZM and so forth."

McTeer argues that the sterilizing process, however, is not occurring any longer. He continues:

"However, beginning in September 2008, that changed dramatically. In recent weeks, bank reserves, the monetary base and other monetary aggregates, have grown very rapidly.

"According to the Fed's H.4.1 releases, as of Thursday, Oct. 23, the Fed's assets totaled $1,804,208,000, roughly double its total of $919,235 a year earlier. Bank reserve balances during the same period rose from $294,225,000 to $301,270,000, an increase of only 2.4%. Thus the monetary impact of Fed activities over the year has been substantially less than implied by the doubling of its assets.

"While an increase in reserves of 2.4% seems low for a year, virtually all the increase is recent, which means it was even lower for most of the year. Bank reserves remained flat up until a few weeks ago even though total bank assets were growing. The monetary base and various measures of the money supply followed that pattern--very slow growth for about a year then explosive growth in recent weeks."

So, if McTeers analysis of what is happening on the Fed's balance sheet is correct in terms of how to interprete it, we would expect if this explosion in bank reserves were to continue inflationary pressures will have to emerge at some point in the future.

But when, where, and by how much?

How, Bob, do you suggest we make these predictions? I'm serious, Bob, I really would like to know. Then we can pool our savings and make a killing by buying in and then bailing out just at the right time.

And one more thing, Bob, (as Richard looks to the left and the right, and over his shoulder), remember not to tell anyone else on this list!

Richard Ebeling

[Bob Murphy]

Richard,

I haven't gone to the source, but McTeer's quotes seem about right. And FWIW, I have been trying to clarify (on radio interviews etc.) that the massive Fed "injections of liquidity" since last September aren't as inflationary as they first sound, both because they are short-term and because of the sterilization. But now it seems the Fed has run out of wiggle room and will have to soon either (a) abandon its support of the banking sector or (b) borrow and/or print new money like crazy.

So in this environment, you're right, I am predicting large price inflation, whereas many others are predicting falling prices. And that means I think people should buy gold, among other possible strategies.

It's true, I'm not saying, "Wait till gold does a triple-dip and then buy it off the bounce from its support set back in October 1984." Rather, I am saying, "From my knowledge of political economy, I see many signs pointing to a huge influx of new money over the next two years. Therefore a gold price below $1000/oz right now is ludicrous."

Yes, I could be wrong, and if I am wrong, then it won't refute Austrian economics. It will mean I misapplied it, by holding some things constant in my mental experiment that in reality will offset the factors I am considering.

But if we are going to say we economists have no idea what is coming, not even whether prices might go way up or way down, then I think the critics of Austrian economics would be justified in accusing us of engaging in mental gymnastics. It would be like an engineer who said, "Yeah I've studied Euclid, but I have no idea how to build a bridge."

It's true, if he tries to build a bridge and it collapses, that doesn't refute Euclid. But it still makes you wonder why he bothered studying geometry and getting a degree in engineering.

[Robert Wenzel]

Bob and Richard,

Given the clarifications Richard made at my site, I have to side with him in that it is very dangerous to predict double-digit inflation in the near future.

The key to my caution, in addition to the general overall problem of making exact predictions with any level of quantitative certainty, is that growth in M1 is surpassing M2 growth. Since people want to hold money in the form of currency and demand deposits, this suggests to me a high demand for money right now, which would mute any price inflation--short term (and who knows what short term means under current conditions).

It seems we all expect the Fed will try and print its way out of the current mess and I think we would all agree in talking to the average person on the street that we would all be comfortable sayng, "It is highly likely the Federal Reserve will try and print its way out of this mess. This will most likely mean huge price inflation down the road." But to say, "There will be double digit inflation in three months" is something I wouldn't be comfortable in saying at all.

That said, if I start to see a slowdown in M1 growth, I am going to get much more aggressive in my price inflation warnings, since to me that is likely a signal that the demand to hold cash is falling.

For the record, I first detected the Fed's sterilization activities back in July:
http://tinyurl.com/6jkkza

[Bob Murphy]

I should warn everyone that Mr. Wenzel does this a lot. "What are you talking about, you can't predict variable X and call yourself an Austrian! And besides, your forecast is off by 13.6%."

[Robert Wenzel]

It's all in the subtleties, Bob.

I would never say you are off by 13.6%---that's quantitative. I would say something like, "If M1 starts to slow, I am guessing fear is subsiding in the economy and thus there is less demand for cash balances, which dramatically increases the likelihood of strong price inflation."

[online verzekeren]

The data explained in this report appears to be interesting, however I may not be able to post appropriate comment related to this topic.