A Credit Theory of the Great Recession and The Long Slow Recovery (or Absence of One)

|Peter Boettke|

Tyler Cowen posted this set of slides with data analysis of why the current weak recovery from the recession like the depth and severity of depression of the 1930s is a consequence of insufficient creation of credit by the banking system.

What is interesting in this presentation is each slide takes on an alternative hypothesis and offers evidence countering that hypothesis.  To economists such as myself, this presents a very good challenge.  What alternative evidence would I provide to show that it is "regime uncertainty", or "hampering of the free market adjustment process through government regulations", or "excessive government spending", etc.?

What argument or evidence would persuade the author of the presentation to the opposite of his position on insufficient credit creation?  What argument or evidence would persuade me that it is not government impediments to the market process?

And, how does one account for the political economy aspects of monetary policy even if one agrees that the evidence in the slides suggests a more activist role for the central bank?  Isn't it possible that the central bank suffers a "planner's problem" as well as a "political power problem"?  (My reading of Selgin certainly suggests so).  Perhaps Milton Friedman, as the slides suggest, would blame the central bank for not providing enough credit to the economy in its time of need, but that same Milton Friedman in Capitalism and Freedom also argued that any institution that is capable of bringing an entire economy to its knees through a sincere error of a few men, is perhaps an institution that a free and vibrant society cannot afford.  

When we take that sort of insight into account, does the policy analysis change as drastically as I believe it does even granting the technical points of economic theory?  And, is it really proper to do economic theory that is policy relevant without incorporating the political economy points at the very beginning?

Comments

[Roger Koppl]

Kasriel says, “The principal factor accounting for the current exceptionally weak economic recovery is not unusually high ‘uncertainty,' . . . but rather inadequate depository institution credit creation.” He then says, “The reason depository institutions are not creating normal amounts of credit is that they . . . remain concerned about current and/or future capital adequacy.”

Are these two statements consistent?

[McKinney]

Haver relies on government statistics, but as Hayek noted in his Nobel speech, often the data we need doesn’t exist. If the only admissible evidence is government supplied data, then Haver wins.

Nevertheless, while his conclusion about the lack of credit expansion by banks is sound, his solution to it isn’t. The Fed has tried QE for over 3 years. Why hasn’t it worked yet? Banks still aren’t lending, why?

The answer doesn’t exist in data form. But bankers have explained it very clearly:

1. They don’t want to lock in big loans for long term at low interest rates knowing that rates are headed up soon.

2. The spread between their cost of money and their profit on loans is way too small for the risk they have to take.

3. Regulators are punishing them for being so profligate in the boom.

4. Previous credit expansion during recoveries went primarily to housing. No one wants to buy houses today.

How will more QEx solve any of those problems.

Today on CNBC they decided that the Fed's "Twist" to reduce 10-yr rates will hurt bank profits and make them less willing to lend. Probably so.

[K Sralla]

"In my view, recessions are due to monetary disequilibrium--an excess demand for money"-Bill Woolsey

The thing that I struggle with in macro is cause vs effect. In my view, it is very hard to isolate cause, as opposed to an effect plus a feedback. Yet such difficulty does not get around the need to probe this issue deeply.

My question to monetarists of all flavors is whether it is possible that they may be unintentionally guilty of avoiding a probing study of cause vs effect by simply holding "recessions are due to monetary disequilibrium -Case closed.”

To make my point clear, I suspect that at the end of the day, many may be attributing "causal power" to statistical aggregates, when from a deep philosophical perspective, these aggregates are really meaningless in terms of causality.

In my view, statistical aggregates by individual actors in a market likely do *feed back* into the decision making and learning processes of those individuals, but yet these mathematical expressions have no true primary causal power, but are merely descriptive metrics. They are simply ways of expressing aggregate realizations that otherwise are hard quantities for individuals to conceptualize.

And thus cause vs effect is the $64 question when it comes to macro.

[J Oxman]

The big question:

Is it supply of credit (banks won't lend) that is main problem, or the demand for credit (businesses don't want to borrow). I don't see how you can get at that question with the data Kasriel is showing.

And, if his only comment against regime uncertainty is that equipment and software purchases are way (after being way negative last year) then he's got a lot more ground to cover.

[McKinney]

Ksralla, that's the problem we face if we try to distill theory from data alone. The macroeconometric tools we have are not up to the task. See Kling's essay: http://econlog.econlib.org/archives/2011/09/on_macroeconome.html

BTW, I showed an engineer relative of mine the business cycle chart from Estey's "Business Cycles" and he commented that the graph looked like an out of control system. He said when the feed back loop has a long lag, it's impossible to control the system. He doesn't know anything about economics or business cycles.

I told him that was an accurate description of the situation because the lags between Fed policy and their effects are too long for the Fed to do what it thinks it's doing.

[McKinney]

The Economic Cycle Research Institute has an interesting take, with slides, at
http://www.businesscycle.com/pdf/ECRI_Changing_Cyclical_Contours_of_the_US_Economy.pdf

They show that the rate of expansion has declined for the past several decades and frequency of cycles has increased.

[McKinney]

Good point, J Oxman. The counterfactual might be the vast cash hoardes that corps have.

[J Oxman]

Another point:

Why are firms conducting so many stock buybacks if they need money for investment?

http://www.google.com/hostednews/ap/article/ALeqM5hV7pO-Q3vqy5IKD8WP2agjHlhTbQ?docId=f1b215be159c4daaa1e1c9f0874bfaa2

Buybacks are zero-NPV projects. It's what good companies do when they have cash but no positive-NPV projects to invest in.

I think Kasriel is missing the trees for the forest on this one. Big companies don't need money; the small companies that do are too risky to lend to right now. After all, you need cash to borrow cash.

[K Sralla]

statistical aggregates (interpreted by) individual actors in a market likely do *feed back* into the decision making and learning processes

-a correction to my sentence in the prior comment that should make more sense.

[Greg Ransom]

Hayek explicitly talks about how the bust will bring a collapse in "shadow money" and liquidity.

Some Credit Suisse economists have a very good paper on the topic.

The phenomena Cowen holds up is consistent with Hayek's explanatory mechanism.

And more could be said about Hayek on what policy options exist in the post-bust period, especially when a secondary deflation / monetary disequilibrium becomes significantly large.

Cowen, of course, is NOT a reliable source on Hayek's macroeconomics.

[K Sralla]

Greg,

What did Hayek mean in the late 1970's when he famously summarized his main disagreement with Milton Friedman by stating (a paraphrase) "Friedman was an adherent of macroeconomics"?

Obviously Hayek thought about monetary issues, but do you think he ever took Irving Fisher and his intellectual decendents all that seriously?

Also, I think that your phrase "the bust will bring a collapse in "shadow money" and liquidity" reveals the heart of the issue I am trying to get at.

What is a "bust", and what is its cause? Does the aggregate statistical phenomena refered to as the "bust" owe its first cause to credit expansion or credit contraction? Or rather is the "bust" simply an inevitable statistical expression of an excess demand for money in the aggregate which is remedied by meeting the increased money demand with the appropriate money supply? If the latter, then what causes countless individuals to suddenly start hording money at the same time?

At least Keynes, with his "animal spirits", and Mises and Hayek with their "cycle theory" posited causal mechanisms, but I'm afraid that monetarism simply seems to punt on these questions. However, is it possible that erroneous attibution of correlation with causation may lead to some very perverse policy prescriptions (both fiscal and monetary) that might actually make the "primary causal mechanisms" worse?

[Jonathan]

@Koppl
They are not inconsistent, they are insolvent!

[McKinney]

Ksralla, until Greg answers, you might look at Hayek's "Monetary Theory and the Trade Cycle." I think it will answer a lot of your questions. It's free in pdf at mises.org in the literature section.

In the beginning Hayek surveys the common business cycle theories of the day. Though written in the 1920's you'll find that they are very similar to what is popular today.

[K Sralla]

If enough entrepreneurs and established businesses, via innovation and creativity, offer widespread new goods and services that consumers will buy, and these goods and services can be produced at a profit, then real wealth expansion in a society can theoretically occur without any expansion of bank credit whatsoever. There are other ways to finance new business ventures and expansion besides bank debt!

With this simple view in mind, it is hard to see how the view that credit is the primary cause of sustained economic growth can be true, even though we may see high correlation between economic growth and credit expansion in a regression.

[Gene Callahan]

"when from a deep philosophical perspective, these aggregates are really meaningless in terms of causality."

You do realize that temperature is a statistical aggregate, right?

[Gene Callahan]

Oh, and also, K Sralla, "credit expansion" is a statistical aggregate as well.

[Troy Camplin]

Yes, and temperature is a measure of a simple physical system as well. And knowing the temperature of the earth on any given day or moment says nothing about the temperature in Dallas, Texas. It's like those people who argue against global warming because it's currently snowing in the location where they are being asked about global warming -- local conditions are no indication of global conditions, and global conditions are no indication of local conditions, even if they are interrelated in complex ways. And, again, that's for a relatively simple physical system. We do not have the luxury of economic processes being so simple.

[K Sralla]

Can Gene Callahan be considered a troll?

[K Sralla]

Can Gene Callahan be considered a troll?

[K Sralla]

What I am exploring is whether a theory that posits that the lack of credit expansion is causing a lack of economic growth may be akin to a hypothesis that holds that a rise in global surface temperature is causing global warming.

If global warming is by definition a net uptake of heat in the volume integral of the earth system, and a measured increase in heat content with respect to time shows high correlation to dT/dt of a 2-D layer of the atmosphere, then as a mathematical formality, it may be asserted that global warming is a function of temperature increase. Yet, it is easy to see that such an assertion is almost meaningless as a statement of science. There is no deep theory of global warming attached to the statement.

Is it possible that we find ourselves in this type of situation with some areas of macroeconomics?

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To economists such as myself, this presents a very good challenge. well said and done!

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