Financial crisis optimism

The world is not going to end.

This blog has a couple of financial-crisis-pessimists (JC & pommy), so I want to give the other side of the story. I accept that we are facing a financial crisis which is decreasing the access to credit and liquidity. I accept that this will lead to a drop in the share market and a recession. However, I believe that (1) this isn’t such a bad thing; and (2) we’re not facing a “great depression” scenario.

When I say it’s not such a bad thing, I don’t mean that recessions are good. However, in some situations they are inevitable. Austrian economists have been warning for many years that the American monetary policy has been too loose and that this would lead to a recession. I believe they were correct.

Austrian business cycle theory suggests that loose monetary policy (interest rate that are too low) leads to mal-investment because the extra money impacts on different parts of the economy at different times and in different ways. This monetary distortion will lead to over-investment in some areas. When prices adjust (which they eventually do) there will be a necessary unwinding of the over-investment… including drops in some asset values and some businesses going bust.

The best thing for the long term health of the economy is to allow this adjustment mechanism to take place. If the government prevents the adjustment, then the mal-investment will increase and we will simply face a bigger problem further down the road. Basically, given their previous decisions, America needs a small recession.

As a side note, I don’t believe that loose monetary policy is the only cause of the current problems. There was also a systematic miscalculation about risk. This was caused by bad regulation, moral hazard caused by implicit government guarantees (especially with Freddie & Fannie) and business mistakes made by people in the financial markets. It is important to admit that there were mistakes made in in the market. Economic liberals do not claim the market is perfect, and specifically with the functioning of the Credit Default Swap (CDS) market we have seen mistakes. This does not mean “the end of capitalism”. The market allows people to make mistakes, but it also provides the best mechanism for resolving the consequent problems.

Further, I don’t think Australia is facing the same problems as I believe our monetary policy has been relatively good, and we have different regulations.

The second part of my “case for optimism” is that we’re not facing a great depression. In 1929, when America (and the world) faced a financial crisis with reduced credit and liquidity, the federal reserve responded by decreasing the money base. As Milton Friedman subsequently explained, that is the exact wrong response. We will not see the same mistake now, insh’allah.

Risk assessments are being revised up, as is appropriate. In the short term we are seeing a dramatic over-estimate of risk, which is creating the credit/liquidity squeeze. The current risk premiums are not sustainable and will not be sustained. It will not take long before money starts to flow to safe businesses. Marginal businesses will certainly face problems, and some businesses will close or shrink (especially in the financial industry). But other businesses will continue to make profits, and they will continue to attract investment. When people see that the sky hasn’t fallen they will calm down and the risk premium will come down.

The bail-out

Given my relative optimism regarding current events, I do not support the US$700b bail-out being debated in America.

Besides concerns about the cost to taxpayers, my main problem with the bail-out is that it saves financial institutions from the consequences of their own mistakes. The idea of the market is that if you make better decisions you get a better outcome and if you make bad decisions you get a bad outcome. The bail-out provides a decision matrix of “heads I win, tails you lose”, which does not lead to optimal decisions.

I think it is important for the long-term health of the American economy that some businesses are allowed fail. Doing otherwise is the financial equivalent of “protectionism”, with (I believe) ultimately the same consequences.

There is also a disturbing double-standard at play, where lower or middle class people are not protected from the consequences of their business mistakes, but high-paid Wall street bankers are saved.

Instead of the bail-out we need to see two things. In the short-term the federal reserve needs to increase the supply of base money to offset against the reduction in the credit multiplier and the hoarding. At the moment we are effectively seeing a reduction in “broad money”. It is the role of the federal reserve to keep money stable, which requires “broad money” to grow at a low and stable level. The federal reserve need to not only add liquidity to the market, but also add actual money to the market (which can be done in a number of ways). This needs to be a short-term policy and monetary monetary policy will need to be tightened later to prevent excessive inflation.

The second response is a long-term response looking at the nature of our monetary system and financial regulations. But that is a topic for another day.

24 thoughts on “Financial crisis optimism

  1. Good article John.

    Recession? Why?

    Have you pumped this through a macroeconometric forecasting model?

    To be more precise “this will negatively affect economic growth”. You might know that there will be a recession. I am sceptical of this without qualification and there has been innaccurate forecasts of a US recession for almost a year now.

    The Austrian model of credit mispricing and resource misallocation is generally correct. I would like to point out that there is always some kind of microeconomic level cause of credit market mispricing, let alone macro level reasons (which can be quite mild – or quite severe). The more laissez faire the system, the less of these price distortions exist.

    There is always some form of malinvestment, but inflationary and imprecisely adjusting central bank monetary policy cause these malinvestments to accumulate to levels that cause a recession.

    A great primer for this is:

    “SHAND, ALEXANDER H. (FOREWORD G.L.S. SHACKLE) The Capitalist Alternative: An Introduction to Neo-Austrian Economics
    Wheatsheaf Books, 1984, First Edition. (ISBN: 0710802625)”

    Which explains the role of labour productivity and speculation in more detail than John and I.

    Bush’s deficits and long term low cash rates (vis a vis the Austraian business/credit cycle theory) and the oil shock (arguably caused by Bush) have created a series of shocks to the American economy, creating their own downward pressure on economic growth (some say recession). I believe this caused the sub prime crisis, not the other way around. Unfortunately, that has opened up a 840 bln USD black hole (which leads to a bigger downturn and possibly [a bigger] recession).

  2. Temujin

    I agree with pretty much everything you write. I’m pessimistic because i see a recession looming (though not a depression) for Australia. The US is already quite clearly in a recession, as is the UK. However, Australia has many things in its favour; a budget surplus, booming exports, high interest rates (which will be cut to stimulate demand), a relatively healthy banking sector and exposure to hard assets that the developing world needs.

    My twin concerns for Australia are its exorbitantly priced property market and its heavily indebted consumer (the most indebted, in fact, in the developed world).

    I also am firmly against the Paulson bail-out plan as it is a bail-out of Wall St by Main St.

    It is intriguing that so many on the Left are so keen to bail out rich investment bankers, and those on the Right want to save the battling taxpayer. How times change 🙂

  3. Pommy — I think the main difference between you and I regarding Australia is that I think house prices will hold up fairly well. They’ve been stagnating for a while, and I think they’ll continue to be soft for the near future… but I think most of the recent increases in prices is representing a real increase in the value of land (adjusted for current regulations).

    Already, rental returns are starting to look fairly healthy.

    Wall street (and the media) is doing a fairly good job of pushing all the right “panic” buttons. It’s worked for terrorists and global warming, so I guess they thought they’d give it a shot. They just shout “the world is going to end, give us a trillion dollars” and the people hide under their beds just holding their wallet out for the politicians to take.

    Perhaps I should try that tactic for myself? 🙂

  4. John, I pretty well agree with much of what you say, although I reserve the right to be very pessimistic 🙂

    Sure a recession is a cleansing exercise.

    My concern and why i support the package is that I think we have a serious liquidity problem with the transmission belts having fallen off.

    We have discussed this before though.

  5. JH
    What’s that joke about economists predicting nine of the last three recessions..or something?

    You say there is a need to increase the money supply, but only in the short term, then should inflation arise again, clamp down on it.

    But which measure of inflation? Greenspan and Bernanke targetted the CPI and as a consequence we had the “Great Moderation” but in reality, inflation had been diverted to housing, the stock market and commodities.

    Thus it seems to me that the Fed (and by extension the RBA) have too narrow a definition of inflation. If this is not fixed, another bubble will emerge.

    You hint at this:
    “Austrian business cycle theory suggests that loose monetary policy (interest rate that are too low) leads to mal-investment because the extra money impacts on different parts of the economy at different times and in different ways.”

    Also, it seems to me that one could summarise the causes of this crisis in just two words: moral hazard. And it will only get worse, for example:

    I suspect that many companies in the US are actually insolvent but have not declared bankruptcy yet because they are waiting for the bailout package to be approved by Congress. If so, then when it is approved (as I reckon it will) we may witness an almighty stampede for Govt handouts.

    Pommy,
    Actually, I know one self-proclaimed socialist who is opposed to the plan because it will bail out the rich. However, I also suspect that he sub-consciously opposes it for another more nasty reason. He hates America (a common affliction among socialists), so I think he would get a sense of satisfaction from seeing their economy tank.

  6. I basically agree with Temujins article and I think it is a good summary. I also share much the same outlook.

    A technicality regarding the great depression. If you accept that the great depression was essentially an economic contraction brought on by trade policy then a contraction of the money supply (either the base money supply or else broad money) would not be entirely inappropriate (because output was in decline). Of course most of the Commonwealth nations were suffering deflation as a quite separate matter prior to 1929 due to Churchill.

  7. E.D. — I agree that moral hazard contributed to a misestimation of the risk of various investments (as I mentioned in the post).

    And I agree that CPI is an imperfect measure of inflation. This is where it becomes important for inflation-targeters to understand the reason for their actions. CPI is one indicator, but it is also possible for inflation to “hide” in asset bubbles. It then becomes a matter of judgement whether an increase in asset values is being caused by inflation or real factor.

    In the US I believe the house price increases included a significant amount of inflation… while I think the Australian house price increases have been mostly in response to real factors.

  8. One reason why these things can hide John is that we use GDP which has a highly “netted” investment figure. For short and medium-run comparisons when trying to suss out the effects of monetary inflation we need to use Gross Domestic Revenue, which has “I” in its gross form as pretty much all business-to-business spending. If we compiled these figures we would see much more clearly where the effects of the extra ponzi-money was hiding.

  9. The comments so far amount to a bit of mutual dick pulling, so I’ll offer an IANAE disagreement.

    Temu Humphreys’ argument, while logical as far as it goes, relies on this premise:

    loose monetary policy (interest rate that are too low) leads to mal-investment … This monetary distortion will lead to over-investment in some areas. When prices adjust (which they eventually do) there will be a necessary unwinding of the over-investment… including drops in some asset values and some businesses going bust.

    If interest rates are “too low”, by definition that cannot be a function of the market but must be a consequence of government intervention. Why does it follow that the market is the best option for correcting the consequences? I find the argument compelling that the government caused it, so the government needs to fix it. And not do it again, obviously.

    What is “mal-investment” and “over-investment” in the context of a free market? If I buy an investment property when the interest rates fall over the next few months, am I “mal” or “over” investing? Do you need a doctorate in economics or just hindsight to know?

    my main problem with the bail-out is that it saves financial institutions from the consequences of their own mistake

    I understand the terms of the bailouts will be unattractive to all but the most desperate institution. Essentially, non-performing loans will be purchased at a significant discount (by auction), allowing the institution to regain liquidity. Eventually the underlying asset will be resold, quite likely at a profit in many cases.

    To make it even more unpalatable, bailed out organisations will be subject to a salary cap. Given the blatant pursuit of management interests at the expense of shareholders, I find that fascinating.

    My main concern is that the bailout won’t work and the economy will collapse anyway. In that case there’s a good chance the taxpayers might own a lot of houses for a very long time. But being an optimist, I’m not expecting that.

    So get your hands off it chaps. Tell me what’s wrong with my reasoning.

  10. What I’d support, is an end goal, a purpose of seeing markets free of the interventions that led to this situation, and some day, the return of a non-fractional-reserve banking system. What I don’t know is how to get there, or when is a good time to try implementing those how-to measures. My suspicion is that people do not act responsibly, nobly when they are under threat. Therefore, I don’t think the middle of a crisis is the time to do it. Mind you, the blind optimism and hubris of a boom is not the time either. Hmmm!

    In any event, the literature I have been reading seems to indicate that out of all the known bank credit crises, two measures are important:

    1) insure depositors funds.

    2) transact on the devalued assets to reset bank balance sheets (either with an equity injection – foreign if necessary, or by swapping bonds for bad assets).

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=641287
    http://www1.worldbank.org/finance/assets/images/wbimf2_w.pdf
    [I have a couple of others as well, but I think I am link limited in my posts. I don’t expect too much support for these as authorities, being Bank of England and a World Bank publications, but at least they give me some background.]

    Whatever happens bank lending will remain low afterwards (the time depends on the legal framework), and while bank balance sheets will be restored, their profitability will be hit for some considerable time.

    The World Bank paper argues that for a system wide problem, there will need to be a temporary purpose built crisis management unit, probably with extraordinary legal powers.

    The point is also repeatedly made: do not apply liquidity measures to a solvency crisis (it has been done before, and it increases the end-run cost). The trouble is – you have to have enough disclosure to know the difference.

  11. As Credit Crisis Spiraled, Alarm Led to Action

    Panic was spreading on two of the scariest days ever in financial markets, and the biggest investors — not small investors — were panicking the most. Nobody was sure how much damage it would cause before it ended.

    This is what a credit crisis looks like. It’s not like a stock market crisis, where the scary plunge of stocks is obvious to all. The credit crisis has played out in places most people can’t see. It’s banks refusing to lend to other banks — even though that is one of the most essential functions of the banking system. It’s a loss of confidence in seemingly healthy institutions like Morgan Stanley and Goldman — both of which reported profits even as the pressure was mounting. It is panicked hedge funds pulling out cash. It is frightened investors protecting themselves by buying credit-default swaps — a financial insurance policy against potential bankruptcy — at prices 30 times what they normally would pay.

    It was this 36-hour period two weeks ago — from the morning of Wednesday, Sept. 17, to the afternoon of Thursday, Sept. 18 — that spooked policy makers by opening fissures in the worldwide financial system.

    In their rush to do something, and do it fast, the Federal Reserve chairman, Ben S. Bernanke, and Treasury Secretary Henry M. Paulson Jr. concluded the time had come to use the “break the glass” rescue plan they had been developing. But in their urgency, they bypassed a crucial step in Washington and fashioned their $700 billion bailout without political spadework, which led to a resounding rejection this past Monday in the House of Representatives.

    That Thursday evening, however, time was of the essence. In a hastily convened meeting in the conference room of the House speaker, Nancy Pelosi, the two men presented, in the starkest terms imaginable, the outline of the $700 billion plan to Congressional leaders. “If we don’t do this,” Mr. Bernanke said, according to several participants, “we may not have an economy on Monday.”

    http://www.nytimes.com/2008/10/02/business/02crisis.html?_r=1&dlbk&oref=slogin

  12. It’s getting even more troubling today as gold is falling which may mean the credit market induced deflation is getting serious again.

    If this is happening because the credit markets are very tight again, the central banks better cut 1% right now or it’s all over.

  13. “federal reserve to keep money stable, which requires “broad money” to grow at a low and stable level”

    I don’t think the Fed managed to do that. Neither did the RBA. Have you seen Steve Keen’s blog?

    I don’t much like Steve Keen’s idea of a solution – inflation. Sounds like you have much the same idea. Wouldn’t that persecute savers, retirees and renters?

  14. Random question that has been bugging me recently (and perhaps one that shows my economic illiteracy):

    Australia’s dollar was strong against the US dollar for quite a while over the last 12 months (I bought a lot cheap on ebay during that period!) But over the last couple of months, the exchange rate has gone crap and the almost 1:1 ratio has dropped back to around 1:0.8

    How does this happen? I thought that the Australian economy was still doing better than the US? I thought the exchange rate was essentially a relative measure of the strength of respective economies. Australia’s economic strength relative to America doesn’t seem to have changed, so why has the exchange rate turned so badly against us?

  15. Shem – beware the simple mythology. The myth works like this.

    Strong Economy = Rising Prices
    Strong Economy = Strong Currency
    But Rising Prices = Weaker Currency

    In other words the myth does not entirely add up. You can have a strong economy with a weak currency or a weak economy with a strong currency.

    Inflation and Deflation basically happen orthogonally to Expansion and Contraction. The former only feed into the latter because humans make commitments that get confounded by unexpected changes in the value of the unit of account.

  16. JC – if the falling gold price is a concern (ie deflation) then the central bank could leave the interest rates alone and just buy gold (thus monetising it).

  17. Shem,
    One of the drivers has been the pull-back in the carry trade. A lot of people were long AUD because of the high interest rate. As their portfolios were hit from other sides they pulled back on their carry positions: selling AUD and NZD, buying back JPY and CHF, etc.

  18. I believe Temujin is right about house land prices in Oz, but I think there will be some ugliness around holiday property markets and in the outer suburbs which 10 years ago were wastelands of negative equity. In my inner city suburb the home prices are not especially high relative to household incomes.

  19. David. You ought to direct your questions about malinvestment to me where I know that my posts aren’t going to be blocked.

    Under 100% backed commodity-money we can say that debt creates wealth when you use it to improve your cashflow.

    The reason for this is that in a hard money world nobody is foolish enough to ever rely on capital gains. Its a high-yield world and cash-flow is King.

    So all this investment in housing is just about all malinvestment, from this point of view. Because housing is a consumer durable and yet we treat it as an investment good. We only treat it as an investment good because of currency debasement.

    Now this talk about malinvestment. This term tends to be thrown around as an absolutist term. But its all relative. In the sense that you can make better and better investments. And ones that make no sense.

    In an inflationary period people make investments that might make sense from their personal point of view but that make no sense from the point of view of the free market being a sort of rational system.

    We all flip houses. We make investments that don’t improve cashflow. But also in the commercial world people make investments that there aren’t the resources for. OR AT LEAST THIS IS HOW IT PANNED OUT UNDER FRACTIONAL-RESERVE-GOLD.

    The quality of investments fall, viewed from a Gods-Eye point of view. But there is also an issue about manufacturers making investments that the resources don’t support leading to cost overuns and long-term projects being abandoned mid-way through.

    ((((((This is what I’ve tried to impress on our young economics grads but so far without success. They seem to think that our trade deficits are all fair and good and that we ought lose our manufacturing. Whereas I’ve tried to explain that our manufacturing is being devastated by these esoteric monetary considerations….)))))))

    But this latter phenomenon doesn’t tend to happen these days in the way that Mises described it. Because our floating exchange rate system and the scope of international trade means that the projects do not now tend to get abandoned mid-stream like that.

    Instead our manufacturers go broke and our trade deficit blows out. Thats your modern Austrian malinvestment resolution right there.

    Under gold-fractional-reserve the malinvestment would lead to projects being abandoned mid-way in such a way as to almost totally mystify the entire community.

    But under our floating exchange rate system what happens instead is our manufacturers make horrendous losses and our trade deficity blows out.

    The last time you had this Misean breakdown where all these projects just shut down and were abandoned midstream, in traditional fractional-gold-standard fashion…..

    …. The last time something like this happened was in Thailand in 1997.

    So we have to be a bit careful now when we toss around this “malinvestment” term. We have to know the history of how this idea was formulated and how the phenomenon reveals itself in the modern era.

  20. Shem. The Australian money supply was collapsing from December last year to about June this year.

    So it isn’t too surprising that it got valuable all of a sudden. Being as the money supply is ultimately the supply of AUD.

    And you see recently with the USD trouble. This also is likely (I haven’t seen the figures) a result of a restriction in USD money supply on account of recent USD ponzi-money collapse due to these bank problems. But this latter I don’t know for sure.

    There is another deal going on with Australia as a commodity exporter. As Terje often points out, excesses of money supply increases overblows the price of commodities. But in this game there are now two players. If both America and China had collapsing money supplies we would see some effect of the AUD via commodity prices. Our dollar would be like a double loser against these two.

    This makes AUD commodity companies good investment plays. Because when this bailout inflation hits town there will be two or three things making BHP or Rio shares go up locally and at the same time our dollar go up.

    And its going to happen. Because the Treasury and the Fed are run by inflationists and thieves.

  21. Attempted post #4
    Has anyone ever seen an audience applause the Austrian Theory of the Business Cycle? Check out these dudes, esp. @6min.

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