Witch Doctor Economics

The economic packages employed by the Bush Administration and extended by the Obama Administration are being increasingly questioned. Similar stimulus policies have been used for 50 plus years, although never in doses so large.

“Stimulus” is merely a euphemism for inflationism and has been since the ideas of John Maynard Keynes hijacked sound economic thinking. Doug Noland commented on the increasing dissatisfaction with such policies:

Throwing Trillions at a highly-speculative and dysfunctional global financial “system” has begun to present itself somewhat as a more conspicuous failure.  The Greeks and Europeans are furious.  And I doubt the ECB is too impressed right now with the “inflationist” prescription of monetizing euro debt issues.  Here at home, confidence is shaken but not yet broken.  The dollar is well-bid and yields are low, so things could definitely be worse.  There should be, however, little doubt that the sequence of Goldman Sachs testimony, violent Greek riots, the eruption of contagion risk, and a quick 1,000 point market downdraft has reversed momentum away from Greed and firmly in the direction of Fear.

Today we have a massive market rally based on the EU reaction to the Greek crisis. Has anything changed? No. More inflationism in an attempt to avoid the inevitable.

No one appears very happy with the economic situation. Even proponents of the economic policies (e.g., Paul Krugman) criticize the Administration for being too timid, not doing enough, not committing enough funds, etc. That is the defense of every economist. The policy action was correct; it was applied either too slow or too small.

Unfortunately, the dominant schools in economics today are intellectually bankrupt. So-called Keynesian economics has never worked, except as a power grab for the political class.

Monetarism, popularized by Milton Friedman, suffers from its mechanistic, empirical and aggregate-based approach. In an era of rapid technological changes in money and money substitutes, historical correlations do not hold. Monetarists are hard-pressed to even define money, no less find statistically stable relationships between it and economic activity. Overcoming these problems still leaves monetarists with a descriptive (correlation) rather than causal model.

So, what are we left with? My answer would be a return to the basics. Economic theory that is not grounded in individual motivations and actions is useless. The two primary schools of  macroeconomics, Keynesian and Monetarist, are divorced from individual behavior. To the extent that we know anything about economics, it is from the field of microeconomics.

Macroeconomics was established without linkages to micro. It is as if it were a separate field. Yet it is not and cannot be. Macro is merely an aggregate of micro. To properly deal with macroeconomics, one must integrate it with microeconomics. Aggregates do not make decisions, individuals do. This divorce of macroeconomics from individual decision-makers is the cause of bad economics and bad economic policy. (For more on this, see Why Obamanomics Will Not Improve the Economy.)

When the government became a large part of the economy classical economics was rejected. It was not rejected because it was wrong so much as it was an impediment to continued government growth. Economics, less scientific than the natural sciences, was corrupted many decades before our so-called anthropomorphic-driven climate change scandal.

For more on this topic, read Doug Noland piece below:

“Liquidationist” Revisited:

John Maynard Keynes dismissed the “austere and puritanical” “liquidationists.”  Over the years, Chairman Bernanke has similarly ridiculed the “Bubble poppers” – those in the late 1920’s that believed the Fed needed to tighten policy to rein in out of control securities leveraging, speculation and economic imbalances.  Dr. Bernanke has blamed “overzealous” central banking for contributing to the Great Depression.

Andrew Mellon has proved the perfect poster child for those seeking to simplify, distort and discredit so-called “liquidationist” analysis:  “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate… It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people”…

History has not been kind to Andrew Mellon and “liquidationist” thinking.  Mr. Mellon could have phrased his views in a more palatable fashion.  All the same, there was actually an expansive body of writings and insightful economic analysis during the late-twenties and into the depression that went significantly beyond moral judgments.  An impressive group of scholars and statesmen from this period believed that the U.S. Credit system and economy had become grossly distorted from a runaway inflation that had commenced back with the outbreak of the First World War.

Those “old timers” had survived repeated inflationary booms, busts and destabilizing monetary instability going back to the 1860’s.  From experience, they understood the perils of rapid Credit expansion and the necessity of reining in excesses early in the cycle.  The “anti-inflationists” were convinced that the only way to return to a more even keel was to bring down the inflated price level; to bring down inflated asset values; to bring down inflated incomes; and to stabilize economic output at more sustainable levels.

After a massive inflation, the “old timers” understood that the only way to return balance and monetary order to the system was through quashing speculation, financial excess and economic profligacy. And this view was much more based on the understanding of the inherent instability of Credit inflations than it was a “puritanical” judgment.  Sustaining a Bubble was certainly not a viable policy option.

From Dr. Bernanke (extracted from his speech, “Asset-Price ‘Bubbles’ and Monetary Policy”, October 15, 2002):  “The correct interpretation of the 1920s, then, is not the popular one–that the stock market got overvalued, crashed, and caused a Great Depression. The true story is that monetary policy tried overzealously to stop the rise in stock prices. But the main effect of the tight monetary policy… was to slow the economy–both domestically and, through the workings of the gold standard, abroad. The slowing economy, together with rising interest rates, was in turn a major factor in precipitating the stock market crash. This interpretation of the events of the late 1920s is shared by the most knowledgeable students of the period, including Keynes, Friedman and Schwartz, and other leading scholars of both the Depression era and today.

…There is little credible evidence of a bubble in the U.S. stock market before March 1928…yet, in part because of the workings of the gold standard, U.S. monetary policy had already turned exceptionally tight by late 1927… Tighter policy earlier would have brought the Depression on all the more quickly and sharply… The Federal Reserve went on to make a number of serious additional mistakes that deepened and extended the Great Depression of the 1930s. Besides trying to pop the stock market bubble, the Fed made little or no effort to protect the banking system from depositor runs and panics. Most seriously, it permitted a severe deflation in the price level, which drove real interest rates sky-high and greatly increased the pressure on debtors. A small compensation for the enormous tragedy of the Great Depression is that we learned some valuable lessons about central banking. It would be a shame if those lessons were to be forgotten.”

Through the teachings of Keynes, Friedman, Bernanke and others we have been taught flawed analysis and educated in the wrong lessons from the terrible experience of the Great Depression.  The doctrine of inflating Credit, while disregarding speculation and Bubble dynamics, is fraught with myriad dangers.  And, well, we’re now 20 months into Dr. Bernanke’s – and global central bankers’ – experimental “helicopter money” and “government printing press” assault on the Credit crisis.   Not for a moment have I expected such overzealous inflationism to do anything other than exacerbate financial and economic fragility.

The financial world would be a safer place today had Trillions of additional dollars (and euros, yen, etc.) of liquidity not been unleashed upon the markets.  After all, ultra-loose financial conditions accommodated 20 months of historic deficit spending in Greece, periphery Europe, here at home and all about.  Massive government borrowing likely fomented heightened trading activity and speculation in sovereign Credit default swap markets around the world.  Clearly, synchronized fiscal and monetary stimulus incited speculative excess throughout global securities markets.

The “inflationists” would argue that fiscal and monetary stimulus was essential for fostering U.S. economic recovery.  A “liquidationist” (“anti-inflationist”) would counter with the argument that the cost of Trillions of additional government debt and related marketplace distortions far outweigh what will prove ephemeral benefits.  Attempts to avert system adjustment and restructuring – efforts to sustain the previous Bubble economy structure – will prove unsuccessful.  This will in large part be because of the enormous amounts of ongoing Credit expansion and monetary profligacy required for such an endeavor.  There are a host of issues related to the government throwing Trillions (of new “money”) at a maladjusted economy.  I have over the years broadly referred to these types of consequences as “Monetary Disorder.”  Some of these effects have made themselves conspicuous of late.

Reflating the stock market has been a key facet of government reflationary measures.  Rising stock prices were instrumental in boosting household and business confidence.  The revival of “animal spirits” in debt and equities markets was integral to much improved sentiment – and the advancement of a bullish consensus view that economic fundamentals were sound and the recovery on sound footing.  And there’s nothing like the cocktail of inflating markets, escalating confidence, and ultra-loose financial conditions to ensure the rapid emergence of speculative excess.

The financial world would be a safer place today had electronic “frequent trading” not proliferated throughout the government policy-induced stock market reflation.  And financial stability was similarly not bolstered by near-zero rates having enticed over $1 TN of money market assets out to inflate global risk markets.  The revival of bullish expectations, the revitalization of speculative excess and the unprecedented flow of finance into riskier assets – in the face of latent financial and economic fragility – has set the stage for another round of financial tumult – along with further investor disappointment and disillusionment.

Perhaps “purge the rottenness out of the system” is too strong.  But the financial world would be a safer place today had zealous government market intervention not bailed out the crisis-imperiled “leveraged speculating community”.  At one point yesterday, the Japanese yen was almost 6% higher against the dollar – and up a stunning 8% against the euro, Swedish krona and some other currencies.  Those that had speculated on “carry trades” – say, borrowing in yen to finance leveraged long positions in euro-denominated Portuguese bonds – were crushed yesterday in what was likely a significant unwind of money-loosing trades.

The reemergence of “contagion” definitely makes the financial world an unstable and uncertain place in which to operate.  A crisis of confidence in Greek debt led to dislocation in the market for Greece’s Credit default swap (CDS) protection – that jumped to Portugal and then quickly engulfed European CDS and beyond.  Dislocation in European bonds and CDS placed significant downward pressure on the euro and upward pressure on the dollar – in the process fostering general currency market instability.  Most commodities (not gold!) sank, while the emerging markets came under heavy selling pressure.  Global tumult incited a flight into bunds and Treasuries, causing additional havoc for myriad other “carry trades”.  Here at home, spreads between Treasury yields and higher-yielding debt instruments (i.e. MBS and corporate bonds) began to “blow out.”  In short order yesterday, the yen melted up, Treasuries melted up, risk spreads widened dramatically and 2008-style deleveraging returned in full force.

Throwing Trillions at a highly-speculative and dysfunctional global financial “system” has begun to present itself somewhat as a more conspicuous failure.  The Greeks and Europeans are furious.  And I doubt the ECB is too impressed right now with the “inflationist” prescription of monetizing euro debt issues.  Here at home, confidence is shaken but not yet broken.  The dollar is well-bid and yields are low, so things could definitely be worse.  There should be, however, little doubt that the sequence of Goldman Sachs testimony, violent Greek riots, the eruption of contagion risk, and a quick 1,000 point market downdraft has reversed momentum away from Greed and firmly in the direction of Fear.

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