It’s The Economy Stupid

Immortal words when first uttered. Now they seem more an epitaph to a failed period of Democratic rule. That the Democrats are about to get thrashed is a just and deserved punishment for a group of timid and divided politicians. That the economy will suffer over the next two years as a direct result of that failure is what makes me most angry. It did not have to be this way.

There are plenty of people all over the world, and particularly in Washington, busily writing books and articles, or giving speeches, arguing that no one saw this crisis coming. Or that once the crisis unfolded no one knew how deep it was going to be. That the US lingers in malaise and is showing every sign of stagnating for a years to come needs an explanation. The best these folks can offer is something along the lines of “stuff happens”.

As my father would say: “tosh”.

In fact: double tosh.

The run up in private debt over the past two or three decades was inevitably going to reach a “Minsky moment” at which point it tips, irreversibly, into an imploding self destructive mess. Beyond this moment debt was being used to pay off other debt. Debt was being given tax advantages so it displaced equity on private balance sheets. Debt was piling up in all sort of wrong places, like Lehman’s toxic balance sheet. Finally, when the economy lost just enough steam, the entire edifice, which was rotten within, was exposed as being so. Confidence was drained away, and the system ground to a halt.

This was both inevitable, and more importantly, predictable. Many analysts foresaw it. That our elite trained economists did not is no surprise. They never studied Minsky. Why would they? He was a follower of Keynes. And as we all know Keynes, the one economist with the right approach, was side lined as being a “minor player” during the great right wing free market resurgence of the late 1970’s and early 1980’s. An entire generation of elite policy makers emerged with no knowledge of the necessary tools to forestall crisis. Instead they relied on the fallacies of Milton Friedman and his students such as Robert Lucas.

Too bad. It is not often that millions of ordinary people suffer because of the mistakes, and hubris, of a few – very few – academics tucked away safely within the confines of their tenured sanctum. But that has happened.

Put it another way: the economy has just gone through its “flat earth moment”.

By which I mean that we have discovered, too late, that the real world does not conform to our pre-existing and preferred theory. Our explanation and thus our policies, were terribly wrong. Our equivalent of the flat earthers are the policy makers who rely on free market ideology. They cannot grasp their error and so are trying to kluge together policies as if they were still correct. They are insisting we accept our fate when we need not. They need to suffer for their error, not us.

This matters.

It really matters.

Because it has cost the Democrats their role as governors and is about to usher in an entire set of even more committed flat earthers.

The reason that Keynes was expunged from memory so quickly – within years – by the classical theorists was that he saw a role for government in economic policy. This made him a heretic. The entire trajectory of economic classical theory, from its roots in David Ricardo in early 1800’s England, to its recent reincarnation under Friedman’s misguided genius, was to defend capitalism. Economists bent over backwards to create arguments that markets are better at allocating resources than governments. It was a decentralized versus centralized argument. Let the people decide for themselves and we all, inevitably, benefit. Adam Smith provided the unifying metaphor when he talked about the “hidden hand” of market forces.

This was a powerful idea. But it is not easy to prove. In fact it is impossible to prove. There is no scientifically proven analysis that says, indisputably, that markets are better than governments. It is, and always has been, a political argument first and foremost. The contortions that classical economists had to go through to provide “proof” are both extensive and debilitating to the truth. Friedman knew as much when he wrote his classic 1953 defense of the utopian and heroic assumptions needed to make the classical edifice work as he wanted.

That millions of regular Americans are now unemployed is testimony to the political influence classical ideas have had. And to their fundamental error.

Markets are wrong frequently. Just as wrong as governments. Indeed, they are so error prone that they need constant guidance and limitation in order to prevent total meltdown. Take away that guidance, eliminate those limits and you will produce a depression. Sooner or later free markets implode. They hit that “Minsky moment” where accumulated debt is repaid from the issuance of new debt rather from cash generated from profits. The entire economy enters into a stage of ponzi finance. Capitalism needs to be saved from itself, which is what Keynes set out to do.

Counter intuitively, the only way out is for the government to issue debt. And this is where we are making our next mistake.

Not only was the crisis avoidable. So too were it consequences.

We could have issued enough debt, and thus run big enough government deficits, to stay afloat. But we didn’t.

Our elite, both at the end of the Bush regime and at the start of the Obama term, failed to grasp the enormity of the task ahead. They were Friedmanite. They believed in the magical self healing power of the market. They ignored the self destructive tendency that markets adopt when finance fails.

As private people shed debt they foist a big problem on someone else: those who own that debt as an investment. This is because debt is only a problem to part of an economy. To the other part, those who own the debt, it is an asset. People in this part of the economy are not over indebted, they are heavily invested. Thus, as business or households get rid of debt, they are forcing that other part, the investors, to accept cash. But the investors don’t want cash. They want earning assets like loans or bonds. They have pensions to pay. They have earnings goals to meet. As the economy sheds debt investors are increasingly unable to meet their own obligations: for instance they cannot pay the pensions they promised because the return on cash is zero. The economy starts to melt down.

The only way to stop this meltdown is to invent a new source of debt. That way the businesses and households can reduce their debt back to a sustainable level, and investors can swap the cash they receive for the other debt and thus maintain their portfolios. There is only one such debt source: the government.

All this gets really complicated when interest rates are at zero.

Why?

Because there is no difference between holding short term debt, like t-bills, and cash. Neither are earning a return. Cash never does, but under normal circumstances short term debt does. That means that to hold short term debt places a price on people’s willingness to forgo that return. Think of it this way: if you hold t-bills you can earn a return. But you surrender liquidity. You cannot walk into a store and spend t-bills. You cannot pay off a debt with it either. First you need to convert it into cash. To do this you rely on there being a market for t-bills. If that market seizes up, just as they did after the Lehman implosion, then you pay the price for not owning cash. You cannot make the conversion from t-bills into cash and you run the risk of not being able to pay your bills. You have a liquidity crisis. When interest rates are so low that there is no return on t-bills some investors will simply hold cash in order to avoid this liquidity problem. More to the point there is every incentive for people to hold cash for that reason.

And that’s where we are today.

In an economy awash with cash, but underinvested.

The private economy has ceased to act according to classical theory. It is in a liquidity trap. The market system has failed. Despite every actor within it being sensible. This is not supposed to happen according to Friedman and his ilk. They argue that when everyone behaves sensibly nothing can go wrong. It was Keynes’ most telling and heretical insight that this is simply not true. It is quite normal for markets to fail even when everything is going swimmingly according to the Friedmanite plan. Doh!

Our issue, and this is the political lesson to learn, is that policy makers have to be able to meet the challenge. They need to understand that markets fail. They need to understand what happens when finance flips into a ponzi state. They need to understand that such crises do not self correct. And they need to match the size of the response by government to the size of the crisis.

Our leadership failed all these tests.

They deserve to be kicked out.

Of course it would be nice were the opposition in any way constructive. Unfortunately this is not the case. On the contrary the likely course of events is that we will be forced down a failed path once again. The economy will fester and 2012 will be just as noxious and fraught an election year as this has been.

And that’s an unpleasant prospect. Especially for the victims of the fraud known as classical economics.