Friday, January 30, 2009

Why Are We Having A Recession?

David Brooks proposes in a recent essay that conventional economic thinking can’t explain the ongoing financial debacle or why we're having a recession just now. He wonders "how so many people could be so stupid, incompetent and self-destructive all at once."

Contrary to Brook’s hypothesis, classical economic models haven’t failed us. Humans have always made mistakes and errors in judgment. That’s nothing new, or even just recently discovered–notwithstanding the findings of Andrew Lo or Jonah Lehrer about human decision making. Most of the time people don’t make large, crucial mistakes about production, consumption, and investing simultaneously. When we do, we get a recession.

Only one explanation can account for millions of businesses, investors, and consumers making such stupid, incompetent and self-destructive mistakes “all at once.” In the United States it takes a central bank and a federal government–a very large, powerful, and well-financed federal government–to cause the “all at once” part. And notwithstanding Tom Friedman’s flat-world hypothesis, it remains the case that when America sneezes, the rest of the world still gets a cold.

Classical economic theory tells us that people make choices they think will advance their own interests, and that they do so by weighing additional costs and benefits they expect to experience themselves. It’s not just “greedy” people who do this–never mind our new President’s eloquent inaugural address. Everyone does it, saints and sinners alike. Costs that someone else will bear, or benefits that someone else will enjoy, usually just don't figure into the calculus.

When commercial banks, investment banks, and other financial institutions believe that they are too big to fail, they don’t worry much about decisions that could cause failure–someone else will bear the cost. The same is true for auto makers. When investors at home and around the world believe the junk bonds they are buying are backed by the United States federal government (bonds issued by Fannie Mae or Freddie Mac), they don’t worry much about default of the borrower–someone else will bear the cost. When homeowners believe the market value of houses can only rise–a result of the Fed openly and blatantly keeping inflation going–they don’t worry about borrowing well beyond their means. So I ask Mr. Brooks, where’s the mystery? Classical economic theory predicts all this and more.

Classical economic theory tells us that resources are scarce; there is no free lunch. Classical theory insists that using scarce resources in a particular way “crowds out” using the same resources in another way. Recently, prominent economists have been arguing again about whether government borrowing crowds out private borrowing. Forget about that kind of crowding out. Using resources one way always crowds out using them another way.

The obvious implication is that government cannot manufacture economic prosperity simply by spending more borrowed money. That implication doesn’t go away during recessions. In fact, the implication is even more obvious during a recession because households’ and businesses’ access to credit shrinks during a recession, making it ever more real to them that there is no free lunch. Recession economics is not different from good-times economics.

The federal government (545 real people) and the Fed (seven governors and 12 regional bank presidents) have been cooperating implicitly in the mother of all Ponzi schemes since at least 1914. Worse yet, since 9-11, the Ponzi scheme has been particularly corrosive. It’s not a conspiracy, mind you. It doesn’t need to be. All the participants are just pursuing their own self interests. It’s just that they have the power to do so while the teaming masses have no way to short circuit the system. Our political system, which concentrates benefits and diffuses costs keeps the power structure in place. As it happens, we can’t vote the rascals out without voting the other rascals in.

Congress spends dollars it hasn’t taxed away from households, creating an illusion that leads households to perceive a free lunch. The Fed makes sure there’s plenty of credit money to finance spending by Congress and households alike. If the Fed keeps injecting new credit money fast enough, the Ponzi scheme can be sustained–at least until something causes a loss of confidence and a panic begins.

Congress likes the Ponzi arrangement because it allows people who want power to get re-elected. The Fed likes the arrangement because banks (who own the Fed) are engines of income for those who make money from money. Billions of dollars of income are generated from lending money the Fed creates out of thin air. It’s worth thinking about who the people are that are the recipients of these billions of dollars of interest income.

When the source of loanable funds is savings of the household sector, interest–the rental price of using someone else’s savings–makes perfect economic sense. But when the source of loanable funds is money created by the Fed, interest and the money from which it accrues is an illusion. When that illusory money commands real resources and real goods and services, it is a form of theft. For the spenders of such money, regardless of who they are, did not produce anything of value to earn the money.

Is the Ponzi scheme a good thing or a bad thing? The answer to that normative question will depend on who you ask. But the positive, classical economics of the scheme are really not mysterious at all.