Thursday, January 14, 2010

Anticipating the sins of [the] Commission

This is a mystery for me: how do ideas and theories once considered disproved get revived and embraced?

I mean, can you imagine if suddenly, as a result of some scientific discovery, we decided to reinstate Newton's theory of gravity and mechanics and discard Einstein's. It is conceivable but barely. Accumulating knowledge usually consigns early theories to history and supersedes them with better ones.

Not so in economics. The recent downturn episode convinces me that economics should probably not be called a science. At least not the way it is practiced now. This is partly a philosophical-methodological question and partly a sociological one. Inquiry in the social sciences (economics, sociology, history, psychology, anthropology, etc.) seems to be fundamentally different from inquiry in the natural sciences. The interpretation of "data" is much more difficult in the social sciences. The isolation of cause and effect is not nearly so straight-forward and human intention and purpose plays a crucial role.

So maybe I should not be surprised to find economists and politicians embracing the once defunct theories of John Maynard Keynes and his followers when interpreting and responding to the crash of 2008. I have explained the nature of this once-defunct theory and recorded my dismay at its resurrection here. It became defunct when Americans experienced stagnation at the same time as inflation in the 1970's and decades of demand-management policies similar to the current stimulus and other government spending programs were judged a failure. The theories that were embraced in its place were those articulated as early as 1912 by the Austrian economist Ludwig von Mises and refined later by both Mises and his younger colleague Frederick Hayek. Hayek was awarded the Nobel prize in economics in 1974 for this work first presented in the 1930's.

It's not a complicated story. Expansive economic policy is fueled by government expenditure in the form of easy credit (low interest rates). Interest rates are kept low by the Fed expanding bank reserves. Loans for private business investment expands. But these investments are unsustainable at higher interest rates. When higher interest rates threaten to choke off an incipient boom the Fed opens the credit tap a little wider – who wants to be a party pooper? But, this means that the extent and type of business investment that occurs is more and more dependent on low interest rates. Eventually interest rates must rise and/or many of these investments are revealed to be unsustainable (even at lower interest rates). A bubble is really a large overinvestment boom – or, more accurately, a malinvestment boom. The bubble must eventually burst.

There are many such examples of credit driven boom-busts in economic history. Each one has its own particularly history. Many are initiated on the back of a technology driven expansion in certain sectors – prime examples being the crash or 1929-1933 and the recent dot-com bust. The even more recent crash of 2008, the bursting of the housing and financial-derivatives bubble is a credit-induced boom-bust that was propelled mainly by a reckless Congressional initiative to expand home ownership by dramatically reducing the approval standards for mortgage approval. Interest rate and risk structures became increasingly distorted as the stock of housing and housing values expanded beyond any sustainable limit. The inevitable bursting eventually arrived as many of us knew it must.

The story is not over. Commercial real estate values are still too high and we may soon see a smaller bubble burst there. Unemployment, the result of the necessary reallocation of resources away from overinvested areas, will not come down any time soon. And policy responses, far from recognizing the need for resource reallocation, seem fixated on the desire to reignite the bubble by trying to revive the housing market or by employing people in other unsustainable ventures.

Now comes the appointment of a Congressional commission of inquiry into the causes of the crisis. Hullo! We know what caused the crisis. It was government policy hubris. It was a housing expansion policy preventing the housing and financial markets from working properly, from sending the right signals and providing the necessary financial brakes (as opposed to breaks).

This commission will now waste more taxpayer money to conclude, contrary to the above story, that it was financial greed and deceit and lack of regulation that caused the crisis and that what is now needed is more regulation and more expansion and government stimulus. The conventional wisdom is an illusion and a lie and it will now be underlined by the imprimatur of a government commission. George Orwell could not have written it better.

No comments: