Saturday, January 31, 2004

Keynesian Economics and the Business Cycle: Or why are there no new jobs and we're about to lose the house?

Brad Delong writes about the current GDP report and the possibility that the Fed intervention has spurred a real-estate bubble. First let me state that Alan Greenspan, the chairman of the Federal Reserve Board, has done in my opinion a good and sometimes great job in minding the economy. However, the power of the Federal Reserve Chairman to affect the economy is primarily Keynesian in its nature.

The Federal Reserve Bank was established to prevent shocks and panics like those associated with the Great Depression. Over time, the role of the Federal Reserve has evolved to mulitples roles such as regulatory, monetary policy, and including the promotion of price stability. A prime example of a failure of price stability was "Stagflation" as occured in the in the 1970's and was associated with Federal Reserve monetary policy as well as the oil shocks of the period. Stagflation is a term coined to denote slow economic growth as well as rising prices.

However the "jobless recovery" (Federal Reserve Board, CSM) is still here unless the February 6th 2004 report is significantly more robust than I'm expecting.

The question is then "why?" is this happening. Keynes advocated a theory of economics that argued that uncertainty (or inefficiency) in supply and demand balances would mean that full employment would not necessarily be reached without government intervention. On the other hand, "Free Market" economists like Mark Skousen argue that government intervention is what creates boom/bust cycles:

" Fortunately, most economists now recognize that government's monetary and fiscal policies are the main source of economic and financial instability in the world today. In fact, more and more college textbooks teach up front that the economy is relatively stable at full employment; this is known as the "long-term growth model." The short-term Keynesian model is taught at the end of the textbooks, where government intervention is recognized as a destabilizing factor in the economy and the chief cause of the boombust cycle. See Roy Ruffin and Paul Gregory's Principles of Economics and N. Gregory Mankiw's Economics."

So if this is the case who is right? Well, unfortunately it seems that both Keynesian and 'Free Market' economists are correct. How can they both be correct? Well, it's quite simple. The Federal Reserve controls interest rates and monetary policy (Fiscal implementation belongs to the Treasury department). Using this power, the Federal Reserve Banking system as the "lender of last resort" can effectively prevent panics and minimize shocks to the economic system. However whenever the Federal Reserve pursues a policy that deviates from true market conditions it creates excesses that build up and cause "irrational exuberance" that may create a financial bubble and the accompanying shock of its bursting. However once the bubble has been created, the Federal Reserve does not have the power to magically wave its hand and make it disappear. It can only once again using monetary policy and setting interest rates manage to "cushion the shock".

John Cochran writes on unsustainable growth of which we saw quite allot of with the Internet bubble bursting.

" Unsustainable growth occurs when the central banks's creation of credit (often accompanied by crony capitalism) allows investment to exceed available savings. The amount and type of investment and growth are not consistent with preferences and resource availability. The process generates significant malinvestment and the possible consumption of capital. The downturn is inevitable because production has been misdirected by central bank action. "

As Christopher Farrell of Businessweek notes there is a discrepency however. The full economic "crash" never happened:

" But when the dot-com bubble burst, the investment Calvinists warned, the market collapse would take both the New and the Old Economy down with it.

" Well, it sure looks like the Internet balloon has popped... But where is the economic crash?"

So what did happen? Well the Federal Reserve intervention prevented "finanical contagion" and a crisis of confidence. This deferred the economic "crash". Why do I say deferred? Well the problem is that the excesses in the system were never wrung out. The asset liquidation as part of the business cycle (and the "Austrian school/theory of economics) hasn't been deflected - it has merely been delayed and shifted from stocks to stocks AND real estate.

As John Cochran notes:
" The recession is the corrective phase of the cycle; market forces have begun to reassert themselves. Once a crisis has begun, policymakers must walk a fine line. If market processes are not interfered with by government policies, the recession that follows the crisis will be sharp and short and will eliminate and correct the past errors and malinvestments. In other words, the economy moves on.

" If the government interferes with the market processes, however, the adjustment may be postponed, but the recession eventually will be more severe and, most likely, more prolonged...

Well that's theory. Are we seeing something like that happen? Well according to Brad Delong we are in fact seeing that now:

" The argument seems to be that when the NASDAQ crashed the Fed sharply lowered interest rates... in a highly normal, expected, and predictable fashion--raised property prices...

" And then--I think the next stage of the argument goes--a positive-feedback loop got going... the Fed's accomodation has set off a real estate bubble--and planted a ticking time-bomb in the American economy, for when the real estate bubble pops the consequences (collapsing consumption spending, large-scale foreclosures and household bankruptcies, corporate bankruptcies, et cetera) may well be dire.

Brad Delong then proceeds to ask: What is the alternative?
" But if it is true that America is embarked on an unsustainable real-estate bubble, and if that bubble is driving high consumption spending, then how, exactly, would raising interest rates help? Raising interest rates lowers the fundamental value of real estate, yes. But the key problem is the gap between the current "bubble" and the fundamental value of real estate. If that's the problem, you don't want to increase it by lowering the fundamental value of real estate, do you?"

Well what is the alternative?
Under the present economic system there are only three choices. The first is to accept that there will be an asset bubble created by Federal Reserve intervention in the aftermath of every intervention to prevent a major shock or contagion situation. The second is to drop full employment as a goal of monetary and interest rate policy. The third is to create better regulation of markets and have the Federal Reserve more closely follow "market factors" that would dictate the interest rates so as to prevent unsustainable growth. In other words, now that the excesses are in place there is no way to "wring" them out of the system. They must be played out in one fashion or another. It is only on the front end, by keeping interest rates and credit standards sufficiently rigorous that unsustainable growth is not produced in the first place. The question is not whether or not Greenspan should have raised interests after 2000 instead of dropping them, but why did Greenspan back off on raising interest rates in 1996.

What happened is that Alan Greenspan raised interest rates, the financial markets got spooked, and then he backed off. This is the mistake that Greenspan should be held accountable for. Given that he clearly perceived the dangers of unsustainable growth, why didn't he stand firm and so prevent irrational exuberance from reaching such heights? The economy needed to be cooled off but he wasn't willing to stay the course! One might argue that it was politically unacceptable to the Clinton Administration, but the independence of the Federal Reserve Board is key to the working of the economy.

Given that we are in this mess now, what is to be done? Part of the problem is that the Federal Reserve Board control of interest rates is (perceptually at least) a blunt instrument. The Federal Reserve pronouncements are attended to much too closely, and the slightest move on their part or shift in the smallest wording is cause for celebration or dismay in the financial markets. A policy intervention approach in which the intervention is more gradual and more incremental is needed. The Federal Reserve Banks change interest rates by buying or selling into the bond markets as well as setting overnight lending rates to banks. A more market style forum where the Federal Reserve can intervene as a driving force rather than setting categorical "break points" is needed badly.

Short Term Solutions to the coming Housing crash.
1. In the short run, the Federal Reserve can take the edge off the real estate bubble appreciation by forcing/advocating the tightening of lending standards. Part of a bubble bursting's sting is not just that people are speculating on an asset and inflating its price, but that they borrow money to do so. The prospect of being forced to pay it back is what drives the fear created by an asset price shock and forces a mass firesale.

2. At the same time, the Federal Reserve can work with the subsidied mortgage lending companies such as Freddie Mac / Fannie Mae to get more real home owners into the market to provide a "base" to support the speculative over-extension.

3. The Federal Reserve needs to work with HUD in order to help develop low-ROI housing nation wide. Allot of the speculation driving the demand in the real estate bubble is for high end homes. This is because high-end homes offer a much higher Return on Investment for the same capital ("dollar for dollar value"). A person can make allot more money buying and selling expensive homes then building and selling low-rent or starter homes on the same lots. By building a strong "base" into the speculative over-reach, you'd get more real home-owners into the market to keep demand up. This is because people often trade-up using the asset appreciation in their first home to finance a better one.

4. Every financial bubble and its asset speculation is typically driven by financial instruments or organizations that facilitate such speculation on the top-end of large scale investment. In this case, the instrument is REIT's or Real Estate Investment Trusts. Typically such instruments in a true asset inflation bubble become riddled with corruption and criminal evasion of regulations. After the crash typically such excesses come out into the full light of day that were ignored during boom times. We could save ourselves allot of pain later by reigning in the REIT's (and other instruments) today before they go bust. By doing so we could again blunt the economic "reset" caused by the correction deferred and magnified by Federal Reserve intervention.

The coming real estate crash is driven by the magnified correction to the economic system that was created when the Federal Reserve attempted to intervene to cushion the shock of the unsustainable growth created by its failure to rein in the economy when times were good in the 1990's. Intervention itself per se to deal with shocks and contagion do not necessarily create such deferred and magnified corrections. Only interventions that attempt to delay the reckoning of unsustainable growth created by a deviation from "true market conditions" in interest rate and monetary policy are subject to this criticism. Thus the Austrian School, 'Free Trade' economists, and Keynesian economists are correct about the value of central bank intervention depending upon the circumstances.

The only way to avoid a large scale crash at this point is to make very fast regulatory and structural changes to the economy that would help dissapate the correction to something bearable. In the absence of such regulatory and structural initiatives we may expect the correction to be worse than the original affects of the bubble deflation shock would have been. This is supported by micro-economic observations of effective "asset-stripping" when home refinance and home equity loans allow individuals to convert asset appreciation and principal payments into consumer spending without decreasing consumer debt. Keynesian style intervention by a central bank can be justified after a period of unsustainable growth, if and only if the delaying of the correction is used to introduce structural and regulatory reforms that would disappate the asset inflation bubble. This would allow the Keynesian goal of full employment to be achieved, while satisfying the criticisms of the Free Market and Austrian School about the wisdom of government intervention. Reforming the markets and introducing structural economic modernization to disappate the asset inflation are the key steps to making modern central bank intervention work.

There is ample sign that the Federal Reserve needs to take action quickly. Recently a small deletion of language suggesting that the Fed might not keep interest rates at their historical low was the cause of a market fallback. This fallback was only halted by the recent GDP announcement which led the investors to believe that Fed would use the "low" GDP growth (4% in fourth quarter) to not raise interest rates. Ironically, this mirrors the over-sensitivity and asset price falls in 96/97 that accompanied interest rate rises then (and in retrospect were signs of an already over-valued market). In fact asset valuation has risen once again to all time highs in stocks, and now also in real estate. This suggests to me along with the current extreme sensitivity of asset prices to Federal Reserve interest rates that we are already nearing a "top" in the market after which an incipient economic crash will ensue shortly. Therefore strong and quick action must be taken NOW or there will be hell to pay in the near future.

Finally, what about the jobs? An asset inflation bubble typically represents an inefficient allocation of capital in an economic system. Asset liquidation as part of the creative-destructive system of Capitalism is needed to free up that money so that it can be used to create new businesses / investments that will create greater economic wealth. Part of the reasons why the jobs aren't being created is that while the Federal Reserve is pumping money in the economy, it is being sucked back up into this speculative cycle. The cycle needs a real economic correction in order to release that money tied up in Wall Street and Trusts back into the ordinary healthy economic networks that form the "real economy" on Main Street. Taking on the regulatory and structural reforms are needed in order to "kick start" the economy back into real growth. Failure to do so will result in spectacular wealth destruction on a scale unpredented since the Great Depression.

Whew! That was a long screed!


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