Keynes lives!

Why Milton Friedman was wrong, and Keynes was right.

Fiscal or monetary, that is the question. Milton Friedman insisted that monetary stimulus alone could solve recessions and depressions. That is to say, the Fed fiddling with interest rates and bank reserve requirements could correct any macroeconomic bubble fallout and liquidity problems. Paul Krugman wrote a fine article laying this argument to rest, since in the current crisis, (and in Japan's of the 90's), interest rates are at zero, yet deflation and other dislocations still threaten. However he did not really delve into why a fiscal stimulus can do what free money to the banks can not. (A slate guy tried to, though).

Meanwhile, David Brooks decides that since he has no understanding of fiscal policy, the whole thing is very risky and shouldn't be attempted (in the hallowed tradition of doubt mongering on tobacco, climate change, etc.). And the Cato institute puts out the ever-helpful advice that what would fix the current economic problem is a large dose of tax cuts.

With all the years and brains devoted to economics since the great depression, one would have thought that more was learned. Indeed, more has been learned, but media megaphones are usually held by those who have other interests than the pursuit of disinterested economic theory. I am no economist, so once again, caveat emptor!

We find ourselves in an odd place. A massive credit bubble has collapsed, slicing values of assets, loan portfolios, loan collateral, and investments of many sorts to fractions of their former bid-up values. The musical chairs of greater-fool (and unregulated) investing has ended, with substantially fewer chairs than players. The prospects of many kinds of future cash/investment flows has suddenly declined, inducing a whiplash effect on the banks that deal in future-denominated assets (i.e. credit). All that free money on loan from the Fed is filling craters that used to be shiny assets but now turn out to be hockey pucks, or, though the magic of leverage, craters of debt.

So the Cato guy is right- funnelling free money to the banks (and even buying up their stock to provide capital) is not going to force them to lend- not in declining economic times when the next shoe to drop may be their own. The banks play a key role in the system, and monetary policy is essential to keep banks solvent, preventing total collapse, and for setting the stage for economic recovery. But it is not enough if lending is not yet attractive, either due to the wounds already inflicted by the collapse, or due to the lack of positive growth prospects.

Monetary policy alone is enough for many things, like slaying inflation, and mild recession balancing. But deflationary spirals appear to be beyond its reach. Banks and other major investors have fled to safety- specifically, to the safety of T-bills, and that is the key to the conundrum. Banks can clear a small profit from investing their zero-rate Fed money at T-bill rates, and any other investor interested in safety goes there as well. So the government ends up with vast amounts of low-interest money siphoned from the economy. What to do with it?

The obvious answer is to recycle it back into the economy, through a stimulus package like the ones being contemplated currently. The point of monetary policy, after all, is to maintain economic activity, especially jobs, so that the tender flame of money flowing around the economy does not sputter and go out. If the banks won't step up to the plate and the government is seeing a glut of cautious investment dollars coming its way, then it simply has to employ those dollars to give the flame a bit more fuel. Of course, if the government spends the money (as it would in a stimulus) instead of lending it (as the Fed does), then it is setting up future generations to pay back all those T-bill holders in the form of taxes.

That is where the theory of a stimulus gets interesting. The ability of future generations to repay all this money is going to depend on whether they end up better off (i.e. more productive) than we are today. If they are, then repayment will be a piece of cake. If not, they may be faced with currency devaluation or inflation as round-about ways of reneging it. The money thus should ideally take the form of investments that serve the common good in economically beneficial ways, especially in the long term. Usually, this kind of allocation is best left to private parties (forgetting for the moment the monumental short-sightedness demonstrated by our management culture in both the dot-com and finance bubbles), but now, of course, willy nilly, this decision is up to the government.

Let's consider a few different uses of the stimulus:

1. Tax breaks, as per the Cato guy. This has the virtue of leaving the decision of how to invest the money with private citizens. Unfortunately, among the rich, the money is quite likely to end up in T-bills or their equivalent once again ... not a productive use of the money at all, either short term or long term. At the lower end of the income spectrum, the extra money is likely to be spent rapidly, which is indeed good in the short term, since it would fuel the flame of economic activity in a generic way. But it would not constitute any kind of productive investment, especially if used towards the basic needs of food and gas that are likely targets. This kind of spending will maintain the economy, but productive investment must change the economy.

Incidentally, we do not know quite how stimulated the economy should be. If it was overheated and inflated two years ago, and if it is depressed and sagging today, where is the happy mean? That is a delicate question, indicating that the stimulus should be kept to a fraction (like 1/4) of the total wealth lost in this downturn. Economists probably have decent ideas about it, however. One sure-fire measure is the unemployment rate. Below is another measure, part of a Taylor rule presentation, courtesy of a treasure trove of economic data at the St. Louis Federal Reserve.

2. Foreclosure amelioration. Plummeting conditions in the real estate market underlie much of the current pain. Banks do not know how much their loans are worth, builders do not know when they will ever be able to get back to business, and wealth continues to evaporate. It would do a great deal of short-term good to prop up the mortgage industry with renegotiations and refinancing, as is being done now with voluntary programs with the banks and breathtakingly low interest rates. But this is dangerous as well, since we do not know what the natural level of the real estate market should be. If the government takes over loans that later slip further under water, what have we gained? Not much. And the unfairness of helping the most profligate mortgage holders while responsible holders get left paying the taxes to clean up the mess is also quite unattractive.

One idea is to develop incentives that encourage banks to resolve foreclosures by transforming them into market-rate rentals rather than evicting and selling at extremely steep losses. The flood of foreclosures is the worst kind of panic selling that hurts everyone- banks, householders, and the economy. The government could use HUD, or another agency along the lines of Fannie Mae to buy up titles to such properties and manage them, for eventual sale when the market improves.

3. Specific projects. Stimulus money would ideally to go into economically beneficial investments, like targeted education, power grid upgrades, green technology, research, broadband upgrades, and health system upgrades. The record of government direct investment is decidedly mixed. It brought us the internet and the highway system, but also the boondoggles of synfuels, hydrogen cars, the space shuttle, and nuclear power. Government tends not to do well in big projects, but can effectively broker small projects, as is done by the peer review system that has been such a stellar method of resource allocation at the NIH.

I'd like to see at least part of the stimulus go to small grants awarded rapidly on a peer reviewed basis on the broadest range of topics, from the arts to green technology to social policy development. Let a thousand flowers bloom, and perhaps a new internet will take root.

These investments will help shape the economy that will remain after the economic crisis is over. Short-term thinking is not useful, and over-allocation to any one sector (like research, for instance) would create unsustainable growth leading to retrenchment later on. Thus we will be shaping consciously what the future will look like, anticipating what the market will do once the current crisis, and the government participation it has called forth, leave the stage.

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Incidentally, we might ask whether we even want economic growth!

• Later link- Krugman narrates the same story, summer 2009.

Economics and biology

A Victoria's Secret catalog gets me thinking about economic stimulation, credit, and regulation.

At this time of hair-raising de-leveraging, the going joke is that "We found the WMD's!". This came up in an excellent piece by Henry Blodget in the Atlantic. But I'd like to suggest a different metaphor- that of cancer, another syndrome of defective regulation/intelligence. Blodget takes the position that the system (and human nature) is built to forget the past, so whatever we learn now will inevitably go up in smoke, in the excitement of the next bull/bubble market. Just as competition is the life blood of economic activity and its associated ills, so selection is the lifeblood of biology, and its associated ills such as cancer.

Over evolutionary time, our cells have acquired ornate mechanisms of growth regulation, so that they divide like hell's bells early on, producing a baby from one cell in nine months, but then slow to a crawl, or in the case of many cells like neurons, enter complete stasis, not dividing at all while doing the work of adulthood. There are many controls over cellular decisions like responding to local damage, living amicably with one's neighbors, and whether to divide, culminating in the most extreme solution to all three- cell suicide, called apoptosis.

The most well-known example of such a regulator is p53, a protein which is positioned at a central nexus, receiving signals about damage to DNA, chemical stresses, and other problems that might warrent holding up cell division or even committing hari kari. When signalled, it binds to various genes on the DNA and turns them on to execute the program of either shutting down cell division (p21/CDK complex), or shutting down the cell completely (Bax/caspases).

Through the inexorable process of natural selection, some cells will find a way around the commands to stop growing or to destroy themselves. They may have DNA damage to the very genes, like p53, that provide that regulation, or their defect may generate vast over-expression of pro-growth signals that become immune to countervailing influences. This is cancer, and it takes several defects in the regulatory system to allow such over-growth to develop.

Is that starting to sound familiar? The financial system is set up with its own selective imperatives, foremost of which is to make money. Once a bull market gets going, as Blodget relates, the naysayers tend to be wrong year after year after year, lose money, and get sidelined. Cheerleaders such as Blodget himself during the internet stock boom, and real estate agents parrotting the mantras of "real estate never goes down" hold the floor while the music is playing and the disease is getting worse. And worst of all, regulators like the Fed are also overtaken with deregulatory zeal, even in cases like Ben Bernanke, who despite being a student of the great depression promoted the idea that regulators had no role in preventing bubbles, but can only hope to clean up after them. The regulatory systems become compromised, and the disease spreads until the music finally stops, and everyone scurries for cover. Thankfully, this disease is not terminal, but it is still extremely painful, and worth trying to prevent.

I think that throwing up our hands in the face of this process (as Blodget fatalistically does) is not acceptable. Biology labors against a far more difficult problem, there being billions years of evolution that went into the cellular control mechanisms that keep us (mostly) alive through reproductive age. We ask medical research to win the "war on cancer", but are we to ask no more of economists than to accede to human psychology, and let wealth and productivity wither periodically for the freedom of the financial markets to engage in speculative excess?

One template to look at is bank regulation. Banks in their regulated aspects did quite well during this crisis- it was the unregulated derivatives, hedge funds, and wildly overleveraged "investment" banking that collapsed, with the remaining investment houses ironically seeking protection by taking the form of regulated banks. Banking regulation restricts leverage to about 1:10, as well as restricting the targets of that leverage- collateralized loans in such things as real estate or businesses with whose operations the bank has some, if not thorough, familiarity. In combination with modest deposit insurance and other guarantees from the government, this makes for a quite stable system.

The amazing thing was that the Fed, other regulators, and congress decided that other actors in the system that made far riskier loans (to speculators in financial markets) could be far more highly leveraged, (1:50 or above), since the government was not directly on the hook through deposit insurance or other guarantees. Even the LTCM collapse did not warn Greenspan and others that this leverage is a disease that could bring down the entire system, while not offering much public good in return. It is, simply, a genteel form of gambling with very, very large amounts of borrowed money.

So, in a rational world, we would have a regulator with general responsibilities to limit leverage, allowing the most leverage in closely regulated and beneficial institutions (banks), while allowing less (instead of more) in speculative and more lightly regulated institutions. Indeed, it has always mystified me why margin accounts at brokerages are allowed at all- borrowing to buy stocks is the surest way to increase market volatility. There is nothing wrong with speculation, which plays an important role in market efficiency, but lending someone money to speculate is like playing Russian roulette, not just for the speculator and the lender, but for the markets and the economy as a whole.

A general leverage regulator is needed because, like the cancer process, financial markets are endlessly inventive (aka "innovative") at devising new ways to gamble. Mutations and lapses in attention will always occur, so that formal rules will always be out of date. No regulatory system is perfect, just as nobody is completely immune to cancer, but we can learn from history and do better, on a speedier time frame than that of evolution. The Fed is ideally positioned to be this regulator, and should have the function of restricting all kinds of leverage added to its portfolio of regulating banks, keeping the currency stable, and promoting sustainable economic growth.

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While I am at it, let me throw out several more pieces of an economic reform program, though this is mostly oriented to the car bailout and general economic mess, not the financial industry specifically.

• Health care: Relieve businesses of the administrative burden of health care by nationalizing it, as per the pending Obama plans, or something more adventurous like single-payer. Businesses should not shop around for younger employees because they are cheaper to insure. Employees should not depend on employers to provide health care. Incidentally, one step towards cost control could be to revise the FDA approval process to have two levels of approval- one basic level for safety and efficacy, as is done now, and a second level for demonstrated cost/benefit advantage over the current standard of care. One cause of rising health care costs (aside from the absurd duplication and expense of private care insurers/deniers) is that new treatments are not put through a rigorous benefit analysis. Drug and device companies relentlessly push marginal products through the approval process, then devote vast sums to advertise them for benefits that are often absent or minimal.

• Pensions: Businesses should likewise be relieved of the administrative burden and cost inequality of pensions, switching to a nationalized program combining a beefed-up social security with government-run 401K funds. Nowhere is the burden of retirement provisioning more apparent than in the domestic car industry. With roughly 2 or 3 retirees for every worker, they are groaning under this burden, and every sensible program to downsize them in accordance with their self-managed decline in market share makes this ratio even worse. Pensions for all companies (and government entities, which are likewise facing financial chaos from their pension obligations) should be immediately nationalized, so that each employer pays a set tax rate per current employee (like the social security system, only not capped by maximum income). This could be a mix of defined benefits as a safety net and an optional 401K-like account with the government, offering a few selections of risk. Then all retirees, including those not employed (such as housewives, for instance) would get a mix of defined benefits and invested returns that are partially tied to their contributions and former income, and partially set as a safety net not dependent on prior work at all. This would allow older companies with many retirees to compete on a level playing field with new startups, give all citizens the assurance of retirement income whether or not they worked or were married to a worker, and allow workers to switch jobs without fear of losing their pension.

• Unions: I support greater unionization, but unions impose costs as well, especially when they are too successful in gaining income and working (or non-working) condition benefits. Unions should organize downtrodden farmworkers and janitors, not dictate no-work jobs, antiquated labor-intensive technologies, and 100K/year longshoreman salaries. My proposal would be that unions be prohibited from representing anyone over the national median income. This would put higher-salaried workers into the regular job market, instead of an artifically negotiated system. What would this do to NBA players? I am not sure- Insofar as management has monopoly power, in this case congressionally sanctioned, workers should likewise be able to organize. However the government's role should generally be to break monopolies, not sanction them.

• Executive pay: The salaries of many corporate and investment managers have been clearly excessive and economically detrimental, motivating them to find beneficial option sale and exit strategies rather than building better companies. Salaries should be capped at 25X the median salary of the managed corporation including subsidiaries. Extra income should be restricted to a new kind of stock option granted on a five year plan, where the grant price is the mean price for the current year, and the options can be redeemed only after five years, at the mean stock price of the trailing year. This would go a long way to re-aligning the interests of management with those of employees and stockholders. There would be no private pensions, parachutes, etc. One interesting side-effect of this proposal would be to motivate management teams to separate themselves from the underlying base companies so that they could be paid more. But since they would have separated rather than subsidiary relationships, this might open a new market for management services, which might enable corporate boards to bid more effectively for these services, enhancing competition and keeping prices down.