Prosperity is not really 'Just around the Corner' after all


In a recent blog post, Paul Krugman wonders about Bernanke's convictions regarding the economy's recuperative prospects. Specifically, he criticizes Bernanke's boiler-plate statements about 'expecting economic recovery' in what is left of 2010 and 2011.


We have to admit, these constant reassurances that 'prosperity is just around the corner' remind one a bit of the Harvard Economic Society in the 1930's and the administration of Herbert Hoover, which in its pep talks always invoked the 'imminent recovery'.

Note however, that Hoover's was anything but a 'laissez faire' administration. Hoover had served as Harding's commerce secretary in the early 1920's, and as such was known to stick his nose into everything. In Washington he was soon called "the Secretary of Commerce… and Under-Secretary of Everything Else!". However, when the recession of 1920-1921 struck, Harding told his busy-body commerce secretary that he would not intervene to prop up the economy. Given that the economy was allowed to quickly purge malinvestments, the stage for economic recovery was soon set, and today almost nobody remembers the 'depression of 1920-1921' anymore. It was over too quickly to register much.

Naturally, Hoover would have none of that non-interventionism when he was president and had the final say on policy. Influenced by Keynes' fore-runners, he thought that wage rates had to be kept artificially high to keep up aggregate spending, he sought to keep goods prices high by imposing massive tariffs, and when none of that worked, embarked on a deficit spending spree that was then the biggest peace time 'stimulus spending' exercise ever seen. So what should Hoover have done? Actually, the best thing would have been to do nothing and wait – for the 'invisible cavalry'.

The invisible cavalry can be seen as a metaphor akin to Adam Smith's 'invisible hand' – the free market, if left to its own devices, would adjust to economic reality, and in the process pave the way for recovery.

In Krugman's Keynesian world-view however, the free market is a priori thought to be defective and in constant need of the bureaucracy's and government's 'guiding hand'. And nothing would be better than government specifically following Krugman's advice to the letter.

In a way we actually agree, since if government did that, the final collapse would arrive sooner rather than later –   on the whole this would be better than the long drawn-out affair we are likely going to be subjected to, as there would be less time and opportunity to consume scarce capital.


Great Depression Needs to be Averted – Again

Naturally Krugman's criticism of Bernanke is therefore meant as an admonition to 'do more' – in this case, inflate more. Krugman wants more deficit spending and more monetary inflation, and he wants it now. His reference to the 'non-existent bond vigilantes' is meant as a reminder that there can be – in his view – no harm in inflating further and increasing the deficit, since the bond market appears at the moment exceedingly unworried by these prospects. The problem with this argument is of course that no-one really knows when the 'bond vigilantes' might wake up.

We only know that if the current policies persist, they will one day wake up. You may well wonder how it comes that so many economists demand 'QE2' (the second round of quantitative easing), when the first round had so little effect. We wonder about that too. See for instance the arguments forwarded by professor Roger A. Farmer in the Financial Times. Ironically his screed is entitled 'We need more quantitative easing to prevent another Great Depression'. The reason this is so ironic is that everybody – including Krugman –  insists that 'Bernanke averted a second Great Depression'.

If he averted it already, why must he avert it again? The antics of the interventionists really should have us rolling on the floor with laughter, if not for the fact that their policy recommendations have deadly serious effects for all of us.

To quote from Krugman's piece (hold barf bag at the ready):


So it seems that we aren’t going to have a second Great Depression after all. What saved us? The answer, basically, is Big Government.”


That was written in August 2009, when the stock market was still streaking higher. It was a tempting conclusion for a Keynesian to come to  – although we note that Krugman was careful to mention that he nonetheless thought 'the Obama stimulus was too small' – in Krugman's worldview, the government can not possibly spend too much. Krugman left open this back door about the stimulus having been too small on purpose: it is standard operating procedure for Keynesians to claim after their advice has been followed and has failed to produce the desired results that 'they didn't spend enough'.

Professor Farmer in his 'QE2' advocacy piece launches into the technicalities of modern day money printing to explain why it can not possibly result in 'inflation' (this is to say, rising prices in terms of the 'general price level' as defined by measures such as CPI). He then promptly attributes what we would call near-magical powers to the policy of QE:


“It is important to maintain stable goods price inflation to promote high employment and stable growth. It is just as important to maintain stable asset prices so that business owners can have confidence that their hard work will pay off. QE, in conjunction with the payment of interest on reserves, provides the Bank with the tools to control goods price inflation and asset price inflation at the same time.”


Wow! Why has nobody thought of this one before? Central bank price fixing can apparently now be fine-tuned into a kind of 'Greenspan put without any negative side effects whatsoever'. We encourage you to read the entire piece if only as a vivid demonstration of how shallow modern-day economic thinking in academia has become (there are of course a number of notable exceptions to this rule, but they are rare). Nowhere in his article does professor Farmer mention that there could be some unintended long term consequences resulting from such a price fixing scheme.

Let us for a moment disregard the fact that his belief that the central bank can really juggle all these balls at once is rather naïve to begin with. Even if it could do that, why would it be desirable to falsify the market's price signals? Farmer thinks that by artificially propping up asset prices 'business owners will have confidence that their hard work pays off'. We would submit that this is really the wrong way of looking at the issue. If the central bank's monetary policy results in an artificial propping up of asset prices beyond their true market value, businessmen may well have such confidence, but the story certainly doesn't end there. After all, this confidence will be utterly misplaced, and therefore lead to malinvestment of capital. This in turn may well create an illusion of economic growth, but in reality, wealth will be destroyed.

Professor Farmer writes as though he doesn't know anything about the recent housing bubble. In 2000-2002, the Fed's loose monetary policy also propped up asset prices. We are fairly certain that real estate developers, home builders, banks giving out mortgage credit, speculators, and so forth were all very 'confident' that their work would pay off in view of the steady rise in house prices. However, was this really a desirable goal of economic policy? Did it not produce the very catastrophe that Farmer thinks must now be battled by even more loose monetary policy?

Good and Bad Economists

What we see here is that most mainstream economists have simply ceased looking below the surface or beyond the near term. It is precisely this attitude that was first criticized by Frederic Bastiat back in 1850 already, in his essay on 'seen and unseen' effects of economic policy.

Bastiat wrote:


“In the department of economy, an act, a habit, an institution, a law, gives birth not only to an effect, but to a series of effects. Of these effects, the first only is immediate; it manifests itself simultaneously with its cause – it is seen. The others unfold in succession – they are not seen: it is well for us, if they are foreseen. Between a good and a bad economist this constitutes the whole difference – the one takes account of the visible effect; the other takes account both of the effects which are seen, and also of those which it is necessary to foresee. Now this difference is enormous, for it almost always happens that when the immediate consequence is favorable, the ultimate consequences are fatal, and the converse. Hence it follows that the bad economist pursues a small present good, which will be followed by a great evil to come, while the true economist pursues a great good to come, at the risk of a small present evil"


Nothing has changed since Bastiat put down these words. We can still differentiate good economists from bad ones by these criteria.

Unfortunately for all of us, Keynesian thought has not yet been discredited enough to for a reorientation of economic science toward subjectivist economic thought to begin in earnest. As e.g. Kartik Athreya's essay on 'economic bloggers vs. real economists' showed, the belief that the social science of economics is akin to a natural science – and thus comparable to medicine or physics – is still deeply ingrained. It is as though economists were afraid that if they did not bludgeon their audiences with truckloads of mathematical gobbledegook they can not be taken seriously as 'scientists'. As a result we have economists producing a pile of econometric research every year, which Athreya menions is a 'hard job', but no what effect?  For some reason all the fancy equations have not prevented these economists from failing to foresee the bust for which they now busily devise 'policy recommendations'. The reality is of course that most of the equations econometricians use in their models are either tautologies – accounting identities based on ceteris paribus conditions that never pertain in the real world and thus tell us really nothing at all – or represent collections of economic data describing economic history.  The attempt to devise sound theories from such observations is an approach that is doomed to failure from the outset.  Every historical period is unique and has so many different inputs – many of which are simply unmeasurable – that no coherent theory will ever emerge from such data mining.

Alas, even the Wall Street Journal recently felt compelled to acknowledge the existence of the subjectivist economic revolution that happened – well, 140 years ago already, with Menger's publication of 'Pinciples of Economics' in 1871. In an article entitled 'Spreading Hayek, spurning Keynes', the WSJ reports on Professor Peter J. Boettke, an Austrian economist who teaches at the George Mason University in Virginia. Alas, as Boettke and the WSJ  point out, the Austrian school's anti-government intervention stance apparently means that 'Austrian economists need to take pains to distance themselves from crackpot conspiracy theorists'. In other words, if you believe the government should stay the hell out of the economy, you're these days still regarded as a 'crackpot'.


Why QE1 Failed to Increase Bank Lending and why the Same Fate Awaits QE2

One of the reasons why 'QE 1' didn't work as expected is that the US banking system is essentially insolvent (the same holds for a number of banking systems elsewhere of course). As we pointed out in an essay on the 'Stress Test Controversy', the FASB ruling that suspended mark-to-market accounting allows banks to report what are utterly fictitious asset values for their portfolios of mortgage loans and mortgage securities. Mish has posted a more recent piece on the efforts banks are putting into keeping a return of mark-to-market at bay. Considering the thin capital cushions of most fractionally reserved banks we are not surprised that they engage in such efforts. Their make-believe profits, which were in the course of the past 18 months mainly a result of lowering loan loss provisions, would disappear in a flash if they had to mark their assets to market.

Even the huge precautionary cash balances that banks currently hold in deposits at the Fed in the form of 'excess reserves' (the extent to which their  reserves exceed official 'reserve requirements' – which are about as close to zero as you can get – is regarded as representing 'excess' in what is an interesting Orwellian semantic twist) are probably not really sufficient to cover the potential losses lurking in their mis-marked asset portfolios. To take the example of Regions Financial, it admits to its marks exceeding market prices by 15%. However, every time the FDIC swoops in on 'bank failure Friday' to close down failed banks, we learn that their assets are generally worth between 30% at the low end to 70% at the high end of their previously stated book value. So even if we generously assume that for the system as a whole, the situation at Regions is a more representative sample, we wonder how reported bank capital can possibly cover the losses that already exist (even though they are now masked by accounting trickery).

Given all that, how is 'QE2' going to change anything with regards to the willingness of banks to lend, and more importantly, the willingness of borrowers to borrow? We would submit that pumping more 'excess reserves' into the banking system by monetizing more assets – which will chiefly consist of government securities, i.e. the safest assets the banks currently hold – will not change these dynamics. All that is likely to happen is that the amount of 'excess reserves' will grow even larger. As long as the money the banks have deposited at the Fed is not used to inflate commercial bank credit, it is not entering the economy and thus doesn't make any difference. Excess reserves only represent potential money supply inflation for as long as they remain unused.

What it does possibly achieve is to give the government more leeway in deficit spending, as a large source of artificial demand for government debt would be in the market. There is after all no practical limit to the Fed's creation of money from thin air to inflate its balance sheet by buying up all sort of assets. If it wanted to, it could buy up the entire Federal debt currently outstanding. The only problem with this is that it would make it too obvious how the game is played – the markets would revolt by repudiating the currency. Indeed, that remains the biggest problem central banks are facing when engaging in QE. Either the policy achieves absolutely nothing – or it actually works and increases inflation expectations, but then the danger of too big an erosion of faith in the currency would immediately rear its head.


Econometricians make a Case for Deflation

The WSJ reports that two noted econometricians – Harvard University’s James Stock and Princeton’s Mark Watson – who in the Journal's words are 'known for teasing meaning out of heaps of statistical data', predict that the current 'slack' in the economy (i.e. the so-called 'output gap') will lead to a bigger decline in 'inflation' than is generally expected.


“Inflation could fall much further in the next year, thanks to the enormous slack that built up in the U.S. economy during recession, two professors say in a paper that will be presented this morning at the Federal Reserve Bank of Kansas City’s annual symposium in Jackson Hole this morning. Harvard University’s James Stock and Princeton’s Mark Watson — two respected econometricians known for teasing meaning out of heaps of statistical data — project that the Federal Reserve’s favored measure of inflation could fall by 0.8 percentage points by the second quarter of 2011 from its 2010 second quarter rate of 1.5%, based on relationships they’ve drawn from past recessionary cycles.”


However, there seems to be a slight problem with the 'teasing of meaning' from the historical data record. There are outliers.


“Mr. Stock and Mr. Watson examined what has happened in seven recessionary episodes since 1960 when unemployment has shot higher. Economists have for decades tried to tease out the connection between inflation and unemployment. The common belief is that inflation falls as unemployment rises, and visa versa. But the connection hasn’t always held up, as in the 1970s. Mr. Stock and Watson changed the standard approach by looking only at the connection between inflation and unemployment in downturns. In the last half century, they find, a sharp rise in unemployment causes what they call an “unemployment recession gap” which pushes down inflation. There is an important outlier in 2004 to their findings. Their model predicts inflation would have fallen during the jobless recovery of 2004. Instead it rose by 0.7 percentage points. “We do not have an explanation for this increase in inflation,” they say.”


First of all, allow us to point out that the ability of the 'unemployment recession gap' to 'push down inflation' is bedeviled by the fact that it is utter nonsense. If it were true that unemployment lowers inflation, then how could Zimbabwe be in hyper-inflation with the official unemployment rate at 80% of its labor force? According to the 'unemployment gap' theory Zimbabwe should have experienced deflation, not inflation. Just as a reminder: the entities creating inflation are not laborers. The entities creating inflation are the banking system and the central banks.

Furthermore, if there is an outlier for which the good professors 'have no explanation' – i.e. a historical example where their data mining based theory did not work as expected – then they must admit that their theory does not work. It either holds in all situations, or it doesn't. Here we see clearly what a problem economists run into when they try to construct theories by way of historicism and statistics. It is simply not possible to create an economic theory in this manner.

Having said all that, we do believe it is possible for the 'general price level' as measured by the CPI to fall further in the near term, just as it is quite possible for asset prices to continue falling in the near term. We therefore expect that Ben Bernanke will eventually heed the admonitions of Paul Krugman et al., and indeed engage in 'QE2' – after all, falling prices are the ultimate bugaboo for Bernanke.



We have little doubt that economists arguing in favor of more money printing will eventually get their way. While we acknowledge that refraining from more deficit spending and inflation would lead to short term economic weakness – it can not be otherwise as the economy still has a lot of malinvestment to clear out – we hold with Bastiat that it would be preferable to accept 'the risk of a small present evil in exchange for a greater good to come' than to strive for a 'small present good in exchange for a great evil to come'. We have already seen what the latter approach means, when the Greenspan Fed interfered in the economic downturn following the bursting of the technology bubble. It did bring us what felt at the time like a 'small present good' – the housing bubble – which turned out to be a 'great evil' in retrospect. Do we really need to do it all over again? This is essentially what Krugman et al. want. It didn't work last time, but they insist that this time it will.

We believe it would be far better to do nothing and wait for the 'Invisible Cavalry' to arrive and do its work. The more the government interferes with the economy, be it via inflation of the money supply or deficit spending, the more likely the 'invisible cavalry' will remain out of sight.




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3 Responses to “Paul Krugman and the Invisible Cavalry”

  • MikeG:

    Nicely presented and, unfortunately, very true

    Remember the most fundamental law of nature

    “There is no situation so dire that Government intervention cannot make it worse”


  • This sentance:
    I do think the government should do one thing, make sure people don’t starve and are housed while this liquidates, but it seems they think an overburden economy with money that only survives because it is universal financial can go on without clearing out the bad choices.

    Should read:

    I do think the government should do one thing, make sure people don’t starve and are housed while this liquidates, but it seems they think an overburden economy with money that only survives because it is universal financial collateral can go on without clearing out the bad choices.

  • I found your website on Mish’s site. I will be back. I have a hard time understanding why the Nobel Prize outfit gives so many prizes to proponents of economic disaster? I have read enough Rothbard and Hayak to see that government interference is not only disasterous in most cases, but leads to a loss of freedom for all and eventually lower living standards. I categorize the current form of economics as some kind of modified fascism. Years ago, they kept talking about how poor of choices Japan made with their economy, yet even then I knew they would use nearly the exact same remedies here. The main difference is we bailed out the banks up front, but we didn’t do anything about the bad debts, which must liquidate themselves and the bailouts only allowed for more management looting of the system. If a drunk driver wrecks a car over and over again, you don’t hand him a bottle and the keys. I do think the government should do one thing, make sure people don’t starve and are housed while this liquidates, but it seems they think an overburden economy with money that only survives because it is universal financial can go on without clearing out the bad choices. If we don’t liqudate this mess, unscrupulous bankers will draw toll of the people of the US and the world for the forseeable future. Most young people are clueless as to the economic freedom that is being stolen daily and the economic ruin guys like Krugman have in their policies. I am beginning to believe that in order to graduate from Harvard you have to border on dishonest and lose your senses.

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