Credit crises, market equilibrium, economic policy and fiat currencies


In the wake of news about President Obama’s new Too Big to Fail Tax and Barry Ritholtz’s post on it, I had an in-depth conversation on the issue with a whole group of people, including Barry. Most of the group was all for the tax.  I am not, as I recently laid out in an Op-Ed in the New York Times. I should add, though, that this is a lot better than the ‘windfall’ tax idea that was floated earlier.

However, because the tax is supposed to claw back money from bankers behaving much as they did in the lead-up to the crisis, the discussion quickly moved away from the current debate on the tax and into a broader discussion about the causes of the credit crisis and a debate about the best policy responses.

How should the government respond in crisis?

On what to do, there are two competing ideas:

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  1. The central bank can try to mitigate worst-case scenarios and potentially hasten recovery by stepping into the fray as an emergency lender of last resort and the government can fill some of the gap left by the private sector in stabilizing demand through fiscal stimulus. Some also argue for monetary stimulus in the form of low interest rates as well; alternatively
  2. The central bank can try to mitigate worst-case scenarios and potentially hasten recovery by stepping into the fray as an emergency lender of last resort and that’s it. Everything else is a market distortion.

Understanding the ramifications of these two competing ideas of crisis response is extremely important. The disagreement goes both to market equilibrium and capital allocation.  In the first case, one would say, once a sharp sell-off in asset prices and a sharp contraction in credit gathers pace, the process feeds on itself in a way that is not just an exercise in mean reversion. This would take an economy into deadweight loss territory. 

It was surprising to hear University of Chicago economist John Cochrane make similar noises about unnecessary real economy effects of panics in a recent interview with the New Yorker. Cochrane said:

We had a financial crisis last fall which was socially not optimal… It seems to me pretty obvious that we had a financial crisis last fall, a freezing up of short-term credit markets, a flight to quality. As a result of that financial crisis, we saw a lot of real effects that didn’t have to happen. Businesses closed and people lost their jobs. It didn’t have to happen. Now in a way, this is what we saw in 1907, 1921, 1849—you can say we’ve seen these things before.

The question, of course, is what to do about it.  While economists in the first camp advocate some level of government ‘activism’, Cochrane, I imagine, is arguing for as little government activism as possible. He says in his interview when asked about fiscal stimulus:

I think it is the wrong question. In many models with positive multipliers it is socially bad to do it. Just because you get more output doesn’t mean it is a good thing. People have pointed to World War II and (said), oh, there’s a case where we had lots of output. “Well, let’s fight World War II again” is not socially good.

His point, of course, is that the government is not necessarily known to be an all-knowing seer which allocates capital efficiently.  Quite the contrary. 

However, I have argued in the past that an economy with high level of private sector indebtedness will be in jeopardy of falling into disequilibrium without fiscal stimulus.  The asset prices underpinning loans fall, causing many to decrease expenditures in order to make up for cash flow shortages that weren’t problematic as asset prices rose.  This in turn lowers demand, people lose their jobs and default, putting yet more downward pressure on asset prices and so the spiral goes.

I certainly don’t advocate propping up asset prices. Price discovery is key.  But, the chain of events I outlined can crush a lot of viable businesses as the economy spirals downward, leading them into bankruptcy. That is what I mean when I talk about deadweight loss.  So, in my view, fiscal stimulus is warranted as long as it is not used as an excuse to prop up asset prices and to maintain a misallocation of capital and resources.  Cochrane is right when he says:

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When we discover we made too many houses in Nevada some people are going to have to move to different jobs, and it is going to take them a while of looking to find the right job for them. There will be some unemployment. Not as much as we have, surely, but some. Right now, ten percent of people are unemployed. Many of them could find a job tomorrow at Wal-Mart but it is not the right job for them—and I agree, it is not the right job for them. That doesn’t mean the world would be right if they took those jobs at Wal-Mart. But some component of unemployment is people searching for better fits after shifts that have to happen.

Where I disagree most with Cochrane is in his discussion about causes of the ‘Great Recession’ and some of his language surrounding market efficiency and rationality. It wasn’t that we had a ‘panic’ or that we had a ‘freeze of short-term debt.’ He makes it seem as if this is a case of clogged plumbing just as the Obama Administration does – the only difference being who the plumber is. 

We had a credit bubble plain and simple.  But that’s a discussion for a different day.

Is the gold standard a way to prevent crisis in the future?

Right now, I want to talk about ways to prevent a future crisis. While we are all talking about taxing the financial service industry, regulating or some other way of controlling animal spirits, there is also the issue of fiat currencies.

A lot of people think a gold standard is the cure to all that ails us. You can point to fiat currencies as inflationary as I did in my post “The Age of the Fiat Currency: A 38-year experiment in inflation,” but that doesn’t mean a gold standard is any better. As a response to that Post, I got a thoughtful response from Rob Parenteau, author of the newsletter started by the late Austrian economist Kurt Richebächer. Richebächer, incidentally, called the housing bubble and predicted its collapse.

Rob’s comment is below. As an investor, you should look at his comments as evidence that the only source of consumer price inflation we are likely to see any time soon is via commodities and oil.

Probably best to remember it is not just fiat currency systems that can end in disaster. A gold standard was in place going into the Great Depression, and the first countries that came off of it recovered better than those who remained on it. It is not just fiat currency systems that fail, in other words – commodity currency systems also have a way of derailing. Barry Eichengreen has done some work on this [pdf file here], but he is not the only one.

Also, there are competing renditions of the history of money and the basis of fiat money which may be of interest. Consider the possibility that fiat currency is "backed" not by some amorphous full faith and credit of the government, but rather by the capacity of the state to impose a liability on its citizens, otherwise known as a tax, and to define what is required to extinguish that liability [see pdf of research by Tymoigne and Wray here].

Finally, seems to me we get into some challenges long before fiscal and monetary stimulus brings any kind of final product price inflation roaring back. With government bond yields pulled down to historical lows by zero nominal policy rates and quantitative easing operations, what private agent is going to be willing to accumulate the huge government bond issuance a) knowing the yield on the bond will barely cover any capital loss if and when Treasury yields rise or renormalize and b) the purpose of QE is to force investors to accumulate riskier assets by trashing cash yields and suppressing Treasury, MBS, and even some higher rated corporate debt yields? In other words, if QE is to be successful, government bonds are unlikely to be the asset of choice. Plus, few pension funds or baby boomer households are going to find a 2.75% yield on 10 year US gets them where they need to go after suffering the largest wealth loss since the Great Depression.

Central banks may end up being the (only?) key bidders at the government bond auctions. As their balance sheets balloon with government bond acquisitions, you may get more investors putting on inflation hedges by accumulating long energy, precious metal, industrial metal, and ag or ag land positions. As those prices rise on stronger investor demand, not stronger end user demand, you introduce adverse shocks to supply curves, as these are generally inputs to final goods production. You also put up the price of essential items like food and energy for consumers. Hard to see how either of these side effects will enhance economic growth. More like a stagflation dynamic, or in the extreme, an almost unthinkable and certainly mindboggling inflationary depression environment.

Not sure policy makers or professional investors have thought all the way through this, but maybe I am missing something.


Interview with John Cochrane – The New Yorker

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