Keynes, Krugman, Black Swans et al

Introduction

 A number of friends, knowing that I am an economist, have asked me to comment on my profession. I have resisted to date. But here we go.

 The economics profession, like all others, is in grown with separate factions that argue continuously. The global recession has opened the door for new back and forth allegations, nicely summarized in a recent article by Krugman.

I break the factions into four groups:

• The neo-classical monetarists who want government to stay out of everything and lower the marginal income tax rate, e.g., Hassett;
• The liberal Keynesians who feel a larger role for government is needed and taxes on the wealthy should be increased;
• The Black Swan types, e.g., Taleb, who are seen as geniuses and “enjoy living in a world we don’t understand;
• The “can-do” economists/engineers who believe more complex risk functions will allow us to avoid future global meltdowns (Brown et al and Colander et al).

 Nobody outside of the Economics profession should be burdened with these internal squabbles. So let me try to clarify what we do know and what we do not insofar as it relates to getting out of the global recession.

 What has my economics background taught me about the credit freeze and resulting global recession? Certainly not that the real estate would lead to a global credit collapse followed by the largest global recession since 1929.

 Some say that in light of this, we should all be humble: “enjoy living in a world we don’t understand”. I don’t buy it. Since the start of civilization, mankind has progressed (and retrogressed). That progression has not resulted from “being humble”. It is the result of arrogant, energetic people trying new things, failing, and trying again. See Hegel, the dialectic.

 When did I first get a hint things were getting very bad? I started worrying after putting together the following table last October for I course I was teaching in the Business School of the University of Palermo in Buenos Aires:

		From 3-yr	Dollar Loss (in billions)
Index	2008	High	2008	From High
S&P	-43%	-48%	-8,538	-9,548
DJ Euro	-47%	-49%	-8,778	-9,071
Nikkei 225	-43%	-54%	-1,876	-2,356
S&P Asia 50	-53%	-59%	-7,185	-8,019
Brazil Bosvesba	-47%	-55%	-641	-747
Argentine Merval	-57%	-61%	-32	-35
Total			-25,043	-29,775

Losses of $30 trillion! That scared me because Keynes had said there was a positive relationship between income and consumption. That meant that when income fell, consumption would as well. To put this in perspective, 2007 global GDP was only $55 trillion. Once those losses had been registered, I knew we were in for a serious recession.

 So let’s move ahead to the recession. Keynes said that in a serious recession, monetary policy (lowering interest rates) would not work. He called it “the liquidity trap”. It meant you could lower interest rates as much as you want, but you would not get an up-tick in consumer or business expenditures. Okay, we are there: in a liquidity trap.

 Keynes said that in such circumstances, government could help by increasing expenditures without increasing taxes (colloquially known as “printing money”) or by reducing taxes without reducing expenditures. Keynes said that either action would have a multiplier effect on aggregate demand: if the government spent new money, at least some of that money would be spent by the recipient. In other words, “deficit finance” would help get out of a global recession.

 Some of you might say that is obvious. You say that because you have become accustomed to Keynesian thinking. But note: in the aftermath of the 1929 depression, Hoover did not know what to do: one of the things he tried was to bring the government budget into balance by reducing outlays and increasing taxes! Roosevelt was also fumbling around. It wasn’t until tried massive public works programs that things started to get better.

So Keynes saw:

• the positive relationship between income and consumption;
• that at times lowering interest rates won’t spur expenditures, and
• that government deficit finance will ultimately increase aggregate demand.

 Enough for one man.

Our problem right now is not with this medicine. It is with how much of it to use and when do we start cutting it off and start going in the other direction to avoid a massive dollar collapse/inflation.     

 Black Swans

 Taleb is now viewed as a genius – one of the few who foresaw the collapse. Before getting carried away with Taleb, I urge you to read Mlodinow’s “The Drunkard’s Walk”. In it, he talks about randomness and how there will always be somebody who accurately predicts an unexpected event. Should that person be revered? No. The prediction could have been an entirely random event. Taleb has surrounded his prediction with supporting facts. But for the global credit freeze to have occurred, we needed close to a perfect storm. Don’t hold your breath for Taleb’s next prediction: chances are it will not be correct.

 Steps to Prevent the Next Global Meltdown

 Almost nobody predicted the credit freeze and resulting global collapse. What do we do next? Engineers have been working on such issues for a long time. They know they can’t design and build for total safety: the costs would be astronomical. So they often design so that the probabilities of failure would be one in one hundred: that is, the system would work unless there was a storm that happened only once in every hundred years.

 The same considerations hold for our economic system. We can’t design for a global collapse. If we tried, the regulations would be so restrictive that the global financial system would become ineffective as a vehicle to get money where it can earn high returns.

Regarding the “can-do economists/engineers” plans to improve risk management, I support their efforts. But we should understand that even without adopting Basel II standards, US government bank managers are totally overwhelmed by what they are being asked to do. In short, there is no way to effectively measure the risks being taken by the large banks. I hope the “can-do” people come up with something that be applied to banks. But until they can, I will repeat a recommendation I made for the US in an earlier posting:

 The Federal Deposit Insurance Corporation insures the deposits in all US banks. That insurance should be limited to banks that manage their own loans and do not engage in extensive trading activities. Get the risk-takers out of banks and caveat emptor in dealing with them.