Myths of the Great Depression

Jim Puplava of the Financial Sense Newshour had a good interview with Robert Murphy summarizing some of the big picture points described in his book The Politically Incorrect Guide to the Great Depression and the New Deal.

Far from getting us out of the depression, Roosevelt’s “new deal” made things much worse. In fact, his “deal” wasn’t even new. He campaigned against Hoover by calling him “the biggest spendthrift in history” (which, in terms of American political history, was true). Then after he was elected, he proceeded to enact a supercharged version of many of the same, failed Keynesian pump-priming measures that Hoover tried (along with a few new and even worse ideas). Giant deficit spending, public works, wage and price controls, attempts to hold up agricultural prices, and the list goes on and on. The myth that Hoover was anything like a free market sympathizer goes hand in hand with the myth that Roosevelt “got us out of the great depression.” Instead, both Hoover and Roosevelt turned a recession into a great depression with a slew of interventionist policies, many of which were precisely the opposite of what should have been done.

Those sympathetic to Roosevelt sometimes describe his methodology as throwing all kinds of things against the wall to see what sticks. This would be bad enough if it were true as it would show that Roosevelt had no idea what he was doing. But it was actually much worse than this as described in painstaking (and painful to learn) detail by John T. Flynn in 1948 in The Roosevelt Myth.

Anyway, useful interview with Murphy to cover some of the big picture basics.

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The Failure of Economic Models

The Financial Crisis and the Systemic Failure of Academic Economics is an interesting exercise in self-flagellation by a far-flung group of academic economists. In this paper, the authors lament the poor state of mathematical modeling in the fields of economics and finance. While they don’t seem to consider or acknowledge that such models may never be adequate for many of their purported tasks, they nevertheless make a number of good critiques of the modeling world in economics. This is an academic paper so it’s filled with jargon and references to models that no one but other academics have heard of. But there are plenty of good points worth highlighting.

In fact, if one browses through the academic macroeconomics and finance literature, “systemic crisis” appears like an otherworldly event that is absent from economic models. Most models, by design, offer no immediate handle on how to think about or deal with this recurring phenomenon. In our hour of greatest need, societies around the world are left to grope in the dark without a theory. That, to us, is a systemic failure of the economics profession.

[…]

Much of the motivation for economics as an academic discipline stems from the desire to explain phenomena like unemployment, boom and bust cycles, and financial crises, but the dominant theoretical model excludes many of the aspects of the economy that will likely lead to a crisis. Confining theoretical models to ‘normal’ times without consideration of such defects might seem contradictory to the focus that the average taxpayer would expect of the scientists on his payroll.

It’s very difficult to model black swan events so the models usually leave out such events and assume that life is always ‘normal’ (in both the casual and statistical uses of the term). And yet, such events aren’t all that rare so there are numerous ways in which the models can and do break down.

Many of the financial economists who developed the theoretical models upon which the modern financial structure is built were well aware of the strong and highly unrealistic restrictions imposed on their models to assure stability. Yet, financial economists gave little warning to the public about the fragility of their models; even as they saw individuals and businesses build a financial system based on their work. There are a number of possible explanations for this failure to warn the public. One is a “lack of understanding” explanation--the researchers did not know the models were fragile. We find this explanation highly unlikely; financial engineers are extremely bright, and it is almost inconceivable that such bright individuals did not understand the limitations of the models. A second, more likely explanation, is that they did not consider it their job to warn the public. If that is the cause of their failure, we believe that it involves a misunderstanding of the role of the economist, and involves an ethical breakdown. In our view, economists, as with all scientists, have an ethical responsibility to communicate the limitations of their models and the potential misuses of their research. Currently, there is no ethical code for professional economic scientists. There should be one.

Here is a point that applies throughout economics. It is often thought that the field itself is and ought to be amoral. Like Dr. Mengele, human social interaction is reduced to an object of study and experimentation. Moral requirements and proscriptions are rarely seen as relevant.

For structured products for credit risk, the basic paradigm of derivative pricing – perfect replication – is not applicable so that one has to rely on a kind of rough-and-ready evaluation of these contracts on the base of historical data. Unfortunately, historical data were hardly available in most cases which meant that one had to rely on simulations with relatively arbitrary assumptions on correlations between risks and default probabilities. This makes the theoretical foundations of all these products highly questionable – the equivalent to building a building of cement of which you weren’t sure of the components. The dramatic recent rise of the markets for structured products (most prominently collateralized debt obligations and credit default swaps - CDOs and CDSs) was made possible by development of such simulation-based pricing tools and the adoption of an industry-standard for these under the lead of rating agencies. Barry Eichengreen (2008) rightly points out that the “development of mathematical methods designed to quantify and hedge risk encouraged commercial banks, investment banks and hedge funds to use more leverage” as if the very use of the mathematical methods diminished the underlying risk. He also notes that the models were estimated on data from periods of low volatility and thus could not deal with the arrival of major changes. Worse, it is our contention that such major changes are endemic to the economy and cannot be simply ignored.

This is consistent with the formula that was used to rate the risk of MBS tranches. The data behind the model were very thin, of dubious relevance, and came from a few years when houses were shooting up in value. Thus, the use of the model to justify pouring billions of dollars into illiquid securities was bound to end badly.

There are some additional aspects as well: asset-pricing and risk management tools are developed from an individualistic perspective, taking as given (ceteris paribus) the behavior of all other market participants. However, popular models might be used by a large number or even the majority of market participants. Similarly, a market participant (e.g., the notorious Long-Term Capital Management) might become so dominant in certain markets that the ceteris paribus assumption becomes unrealistic. The simultaneous pursuit of identical micro strategies leads to synchronous behavior and mechanic contagion. This simultaneous application might generate an unexpected macro outcome that actually jeopardizes the success of the underlying micro strategies. A perfect illustration is the U.S. stock market crash of October 1987. Triggered by a small decrease of prices, automated hedging strategies produced an avalanche of sell orders that out of the blue led to a fall in U.S. stock indices of about 20 percent within one day. With the massive sales to rebalance their portfolios (along the lines of Black and Scholes), the relevant actors could not realize their attempted incremental adjustments, but rather suffered major losses from the ensuing large macro effect.

Not only did Long-Term get so big that its models’ relevance bent under the hedge fund’s weight, it also suffered from “synchronous behavior” that neither the models nor Long-Term’s partners accounted for. Most of the big banks and numerous hedge funds were making many of the same trades as Long-Term (e.g., bond arbitrage, interest rate swaps, Russian bonds, equity vol.). The partners thought that there would be others who would pick up those trades if and when they had to bail but in fact, the opposite occurred. When the other big rats started to jump from the sinking ship, the weight transfer only made the ship sink faster. The partners could only watch helplessly as their illiquid assets plunged in value and the hedge fund quickly burned through its puny capital.

This leads to a related and well known example of synchronous behavior that the models don’t account for: the near truism that in a financial crisis, “all correlations go to one.” In such a situation, portfolio diversification is nearly impossible because even completely unrelated assets fall in lock step with each other. This is because they aren’t completely unrelated. Even though the assets themselves may be unrelated, they are owned by the same parties – hedge funds for example. And when such parties are forced to sell (due to margin calls for example), they can’t be too picky about what they sell. In such cases (which are quite common in crises), unrelated assets get nuked in parallel as the various parties try to raise capital by selling whatever will move. All correlations go to one and the models’ accuracies go to pot.

A somewhat different aspect is the danger of a control illusion: The mathematical rigor and numerical precision of risk management and asset pricing tools has a tendency to conceal the weaknesses of models and assumptions to those who have not developed them and do not know the potential weakness of the assumptions and it is indeed this that Eichengreen emphasizes. Naturally, models are only approximations to the real world dynamics and partially built upon quite heroic assumptions (most notoriously: Normality of asset price changes which can be rejected at a confidence level of 99. 9999…. Anyone who has attended a course in first-year statistics can do this within minutes). Of course, considerable progress has been made by moving to more refined models with, e.g., ‘fat-tailed’ Levy processes as their driving factors. However, while such models better capture the intrinsic volatility of markets, their improved performance, taken at face value, might again contribute to enhancing the control illusion of the naïve user.

The assumption that asset prices are normally distributed was also a major problem with Long-Term’s models even though the error of this assumption was known at the time. Life is full of “fat tails.” In other words, the supposed “once-in-a-thousand-years perfect storm” seems to show up, in one form or another, about every decade or so.

Many economic models are built upon the twin assumptions of ‘rational expectations’ and a representative agent. ‘Rational expectations’ forces individuals’ expectations into harmony with the structure of the economist’s own model. This concept can be thought of as merely a way to close a model. A behavioral interpretation of rational expectations would imply that individuals and the economist have a complete understanding of the economic mechanisms governing the world…. Leaving no place for imperfect knowledge and adaptive adjustments, rational expectations models are typically found to have dynamics that are not smooth enough to fit economic data well.

Technically, rational expectations models are often framed as dynamic programming problems in macroeconomics. But, dynamic programming models have serious limitations. Specifically, to make them analytically tractable, researchers assume representative agents and rational expectations, which assume away any heterogeneity among economic actors. Such models presume that there is a single model of the economy, which is odd given that even economists are divided in their views about the correct model of the economy….

The major problem is that despite its many refinements, this is not at all an approach based on, and confirmed by, empirical research.5 In fact, it stands in stark contrast to a broad set of regularities in human behavior discovered both in psychology and what is called behavioral and experimental economics. The corner stones of many models in finance and macroeconomics are rather maintained despite all the contradictory evidence discovered in empirical research. Much of this literature shows that human subjects act in a way that bears no resemblance to the rational expectations paradigm and also have problems discovering ‘rational expectations equilibria’ in repeated experimental settings. Rather, agents display various forms of ‘bounded rationality’ using heuristic decision rules and displaying inertia in their reaction to new information. They have also been shown in financial markets to be strongly influenced by emotional and hormonal reactions (see Lo et al., 2005, and Coates and Herbert, 2008) Economic modeling has to take such findings seriously.

Mathematical models of human action which contain dehumanizing assumptions that fly in the face of real world experience? Who’d of thunk it. But the illusion of control has a nasty bite to it.

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Our Ponzi Banking System

“Give me a lever big enough and a place to stand on and I will destroy the world.”

Oh, wait. That’s not exactly what Archimedes said. Of course, Archimedes never dreamed of the kind of ingenuity alchemy that would be practiced by our modern financial “wizards.” All they needed was a minuscule amount of capital and a lever arm so long it bent under its own weight.

I found a good intro. to bank leverage at Option ARMageddon. The first installment provides 2008 Q3 bank leverage calculations along with a discussion of how dangerous such leverage is. There are a couple of shorter follow-up posts here and here. The leverage calculations were recently updated for Q4 here. As the posts point out, these leverage numbers are likely to be conservative because they don’t account for “other assets” or off-balance sheet assets (e.g., special investment vehicles). Yet the numbers are still scary large.

In the “good” times, a bank with a 30x lever would make a 150% return on equity when its assets appreciated by just 5%. But now that the bill for this unsustainable leveraged credit bubble has come due, this same bank would be insolvent if its assets dropped by just 5%. And the collateral that is behind much of these assets has obviously fallen by far more than 5%. As these losses become actualized by the foreclosing housing market and a tanking economy, the pressure will mount on the bank to mark these assets to market (i.e., what the market is willing to pay for them today) instead of marking them to model (i.e., what the bank’s management optimistically thinks the assets would be worth in a stable and only slightly depressed market) thus exposing the bankruptcy of the bank’s business model. Since a 30x bank can only absorb a small portion of the losses, the rest of the losses must go elsewhere. And since the other big banks are also levered up with these tanking assets, they can’t deal with their own slop much less take on more slop.

This means that you (the taxpayers) get to bail out the guys who were getting crazy rich from the lever arm in the up years. You never saw any of these bonuses, of course, but you will certainly see the losses. They received the 30x profits but you’ll get much of the 30x losses. Our government will ensure this in order to avoid the cascading cross defaults that would result if these banks were to begin falling. When Lehman went down, the financial markets nearly ground to a catastrophic halt as Lehman’s levered losses threatened to bring down its numerous counterparties and credit default swaps (insurance contracts taken out on financial instruments such as bonds that pay out if and only if the instrument defaults) on Lehman’s debt were triggered that crushed AIG (which was also heavily leveraged with very little capital and huge credit default swap obligations). The government and the Fed had no choice but to jump in and stop this massive domino pattern from erupting (whether or not their actions were the best of the available options is another matter).

But as the latest numbers show, the banking system is still highly leveraged. The more the economy falls, the crappier these bank assets will become. It hardly looks like we’ve found the bottom yet. The scary scenario is this: the leveraged debt bubble is so big that even if the Fed prints money with both hands flailing, it still wouldn’t be enough to fill the credit black hole as it implodes. I don’t know how likely this is but the banks’ balance (and off-balance) sheets don’t inspire confidence.

Obviously there is nothing “free market” about a system predicated upon dumping huge economic externalities onto the rest of the economy and especially onto taxpayers (i.e., the banking version of an industry-wide pollution racket designed to lower the costs of production). The gains were all privatized while most of the risks and costs were socialized. Even apart from our fiat currency or the usual Fed manipulation of money and credit, the free market was dead in the banking sector years before the first bailout.

Bernie Madoff was a lightweight. Unlike our ponzi banking system, his puny $50B scheme was never a threat to bring down the entire world financial market.

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Just Say 'No' to Monetary Fascism

The popular uprising against central banking

http://www.amconmag.com/article/2009/feb/09/00016/

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There is No Paradox of Thrift

http://mises.org/story/3064

Frank Shostak on why the paradox of thrift/deleveraging is no paradox at all. Economies bloated with hot air (i.e., phony, leveraged credit) need to deflate and save. The real paradox is how otherwise intelligent people can think that a leveraged, debt-ridden country with dwindling savings can fix its economic problems with more debt and spending.

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Krugman Doesn't Understand Recessions

http://globaleconomicanalysis.blogspot.com/2008/12/krugman-still-wrong-after-all-these.html

Back in December, Mish ripped Paul Krugman's discussion of "the hangover theory" of recessions.

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What's Wrong with Fiscal Stimulus?

“We’re all Keynesians now.” Nixon didn’t actually say this, but judging by what is being said these days by many politicians, news outlets, and economic pundits, this mythical assessment certainly seems to be true today. Many have jumped on the fiscal stimulus bandwagon. If we just spend a gazillion dollars we don’t have, we’ll create jobs and kick-start the economy back to life. But how much sense does this make, and why is it that no one seems to count the opportunity costs of such stimulus plans? What will we actually accomplish and will it be relevant? For now we’ll bypass the question of whether or not the government has the authority and responsibility to spend taxpayer money for economic stimulus and just address its consequences.

The first question we should be asking is, “Why are we in a recession in the first place?” This rarely seems to matter to Keynesians who just want to spend money in an attempt to prime the economic pump. References to animal spirits don’t explain anything or alternatively, such references could potentially explain everything (which is just as useless). But if a substantial cause or exacerbating factor of the recession was a prior inflationary bubble fueled by reckless borrowing and spending, it seems rather problematic to attempt to solve this problem with more borrowing and spending.

Moreover, Keynesians usually see deflation and recession as causes to be counteracted or as problems to be fixed. But what if a deflationary recession is the cure/fix? What if a recession were the market’s attempt to clear itself of credit-driven overproduction and rebalance misallocated resources? In this case, injecting more fiat money into the economy and/or trying to prime the pump with government spending would fall somewhere between irrelevant action and action that is diametrically opposed to the cure and that prolongs the problem.

In fact, all of this is the case. Easy credit, artificially low interest rates, and leverage helped propel large amounts of ill-advised borrowing/spending, and deflation is precisely what is needed for the market to rebalance after such an inflationary binge. A recession is simply the way in which the market purges itself of a general overproduction of goods and fixes the prior misallocation of resources. At best, fiscal stimulus is an irrelevant waste of money that will probably pump up a few consumption-dominated statistics (e.g., GDP) for a while. But more often than not, such stimulus also involves an attempt to fight a symptom and in so doing, it actually retards the cure.

We have been on a debt-fueled binge for years and it is no longer sustainable. The last thing we need is the government to step in where the private sector left off and continue the same binge with new debt of its own. People need to start saving money so that future investments will be backed by capital we have actually accumulated instead of being based on debt and leverage. The market needs to liquidate inflationary bubbles and re-balance misallocations. These aims are not furthered when the government tries to blow new bubbles thus creating new misallocations. As far as recessions are concerned, fiscal stimulus spending is a complete non sequitur.

There is also the general problem of what Jim Rogers refers to as transferring capital and assets “from the competent to the incompetent” and the inefficiencies and economic drag that this creates. Depressed sectors are depressed for a reason. Failing companies are failing for good reasons. When we take money from the economy at large (either through tax changes, borrowing, or inflation) and give in to the “troubled” parts of the economy, we are directly contravening an important and necessary aspect of capitalism: the liquidation of poor/failed ventures for the benefit of good/thriving ventures. This inversion of market forces adds a long-term depressive aspect to the economy instead of a stimulative one. We get more of what we subsidize and less of what we tax.

The second big question we should be asking ourselves is, “Where will the federal government get the stimulus money from?” What follows is an analysis of the alternative sources.

1. Raise taxes, borrow from loaned up banks, borrow from banks w/ excess reserves that they will not part with; borrow from the private sector

This simply takes money from circulation and redistributes it. It therefore adds no new spending/stimulus. The government simply redirects the money into investments that were less valued by the market (otherwise the market would have already spent the money on those investments). Investors would have directed the money towards other sectors and investments but the government stepped in and redistributed that money elsewhere. This lowers prices in the sectors where the money would have been spent thus depriving some sellers in these sectors while it bids up prices in the sectors where the money is actually spent thus pricing the marginal buyers in these sectors out of the market. This adds a layer of inefficiency and distorts the market. Such an effect is especially problematic in a recession because sectors need to rebalance (some more than others) in order to clear gluts and malinvestments. The bottom line here is that some sectors receive a short-term, debt-fueled boost, some sectors pay the price via a short term drag, and resources are poorly allocated.

In addition, money borrowed on the market will add a new and large bidder to the capital markets thus raising interest rates above what they would have been w/o this extra bidder. The private borrowers at the margin are priced out; they don’t get the funds they need and suffer economic loss because of this. Others will pay more to borrow funds thus increasing their costs (and leading to an increase in their prices) and lowering their return. Some people will get economic stimulus while others will pay the price. On the other hand, tax increases will add a new burden to the whole economy thus adding a depressive aspect to the useless redistributive aspect.

2. Monetize debt by borrowing from the Fed

This adds new money to the economy (i.e., inflation). This new money will bid up prices in the sectors to be stimulated. Marginal buyers of these sectors will be priced out of the market and suffer economic loss. As the new money flows throughout the economy, it pushes prices higher than they otherwise would have been (keep in mind that this could take the form of stable prices when, in the absence of the new money, prices would and should be falling). Those who get the new money early get the benefit of the pre-inflation prices while those who get the new money later will pay more for the goods/services they buy than they would have paid. Those on fixed incomes are victimized the most as their purchasing power is looted and redistributed. The economy eventually has more money but prices are also higher than they would have been.

This increase in prices includes the price of credit. When lenders find out that the government is monetizing debt, interest rates will rise (or fall less than they would have fallen in the absence of the new money) so that lenders can protect themselves from the anticipated inflation. The marginal private borrower will be priced out of the market while other borrowers will pay more for credit thus lowering their overall rate of return and pressuring them to raise prices. If the Fed tried to counteract upward pressure on interest rates by buying a significant amount of treasuries from the market, this would artificially balance the credit markets but it would create new problems (e.g., interest rates that are held lower than they would be based on non-manipulated credit market conditions and a manipulated money supply would further the same easy credit binge that brought us this mess). More manipulation doesn’t eliminate policy costs, it simply shifts them around so that they reemerge in a different place and/or form.

3. Borrowing from commercial banks w/ excess reserves where the banks allow reserves to fall

This would seem like a remote possibility. All other things being equal, new government borrowing should not induce banks to lower their reserves. If they have substantial excess reserves, they must have good reasons for it (like a financial crisis perhaps). Government borrowing shouldn’t change those reasons. Nevertheless, under this situation, new money would be added to the economy and the effects would be similar to those produced by government borrowing from the Fed.

4. Tax cuts as direct stimulus

This would be much less problematic than the previous options if done the right way. For example, rebates are no different from stimulus checks. They are one time or short-term payments that don’t provide the sustained improvement that is necessary. And because they are indiscriminate transfer payments, they don’t do what tax cuts are meant to do: lower the burden on productivity and encourage work. Tax reductions must therefore take the form of sustained marginal rate cuts on labor, capital, and business activity.

However, the Laffer curve not withstanding, this would still be no silver bullet. It would be helpful for removing some of the burden on the economy but tax cuts don’t and can’t address the cause of the problem: the prior inflationary boom which resulted in overproduction, debt accumulation, and misallocation of resources. Tax cuts lower one of the burdensome constants of the equation but they don’t address the variable part of the equation: the boom and bust cycle itself. Taxes in the US are far too high. They should be lowered, but this doesn’t have anything to do with the business cycle.

5. Sell federal land

This would require the sale of a massive number of acres – a move that would significantly depress land prices in an already depressed market (this assumes the government could even move enough of this “product” to raise a significant amount of funds). It would also take far too much time to implement. While a theoretical possibility, it is never a serious option.

Now that we’ve reviewed some important short and medium term effects of the various options that the government has for raising money, we should mention the primary long term effect that results from most of those options. Any borrowing along with tax cuts will add to the public debt, a burden that will eventually need to be repaid by someone. Since government debt is almost never repaid in short order (i.e., 1-5 years), this amounts to a tax on future taxpayers to pay for the indulgences and mistakes of current taxpayers. The two groups will have substantial overlap for a decade or two but some future taxpayers will be paying a bill they never helped run up. This is stealing from the future to pay for the present, and the longer the debt is held, the greater the amount of money that will be stolen from future victims to pay off the currently generated debt.

Moreover, these future payments on the debt will burden the economy by diverting resources. Instead of producing and buying useful goods/services, these future payments will go to pay down the glutinous national credit card bill.

This debt adds an additional cost in the form of interest. Some claim that the new debt we are now accruing is not much of a problem in this regard because current interest rates are so low. This is true now but the potential for a significant problem in the not too distant future is large. It is almost surely the case that the government will not run significant budget surpluses in the near future. This means the new debt, along with the old, will need to be rolled over. As interest rates rise, this will add billions of dollars to the cost of servicing the debt at the same time that entitlement costs will be rising substantially. If we have a $15 trillion debt that starts to roll over into bonds costing 8-12%, the phrase “international debt crisis of the 1980s” may start to show up in more and more news articles. If we think our budget is being mismanaged now, wait until yearly debt servicing payments push past $1 trillion.

The bottom line here is economics 101: there ain’t no such thing as a free lunch. In order to raise new money for a fiscal stimulus plan, the government can deficit finance by borrowing, deficit finance by cutting taxes, raise taxes, or inflate. All of these actions (with the partial exception of intelligent tax rate cuts) cause numerous market-distorting, debt-accumulating problems, have limited and questionable benefits, and are irrelevant or even exacerbating when it comes to the real problem. We got here by way of distorted credit markets, debt, leverage, and a lack of saving. Even if we manage to manipulate some consumption-dominated statistics for a while, we’re not going to solve the problem with more of the same.

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