Economic Theory

Megan McCardle is trying to spark an interesting discussion on economic theory in light of the financial crisis. I added my 2 cents to the comments, which are:

If followed, the right theory will never come in contact with the enemy, because it will tell policy makers how to avoid such contact. Milton Friedman's theory on monetary policy took hold in the 80's and have been the basis of world monetary policy ever since. No one is discarding Milton Friedman's monetary policy theories because of this crisis. In fact, all policy makers are building their bailout policies in accordance with that theory because of its strength. So, if his theories are so sound, why did the theory come in contact with the enemy? Because his theories on government fiscal policy have been ignored for 70+ years, and to be fair his theories on government fiscal policies while strong are more ideological rather than based upon a theoretical framework. Economists need to provide a strong theoretical framework which shows that Milton Friedman's views on government fiscal policy are theoretically just as strong as his theories on monetary policy.

Money Supply Contraction

In the Wall Street Journal, Andy Kessler writes:

...after the 1929 market crash and subsequent bank runs, 10,000 or roughly 40% of banks failed, $2 billion in deposits were wiped out and 30% of the money supply disappeared. So did a similar percentage of GDP. Today, bank deposits are mostly safe, but with $1 trillion in bank and Wall Street writedowns taken or soon to be taken on bad real estate securities, some multiple of that in money supply will vanish with the stroke of an accountant's pen. Restarting bank lending is the only way to top it back up.

The contraction in the money supply is what will trigger the depression. It must be avoided. Desperate times call for desperate meaures.

John Maynard Keynes

Robert Skidelsky, a John Maynard Keynes biographer, writes in the Washington Post:

So mainstream theory has no explanation of why things have gone so horribly wrong. To understand how markets can generate their own hurricanes we need to return to John Maynard Keynes.

I wonder if this author is an economist, because I do not think he knows what he is talking about. For example, take the following passage:

...Keynes's insights should not be tossed away as old garbage. At the very least we can say that we have no warrant for basing economics on assumptions that are so often discredited by events.

The reason that "Keynes's insights" regarding monetary policy were "tossed away like old garbage" was because they were "discredited by events".

Furthermore, even though its true that economist have forsaken Keynesian monetary policy, America has had an unbroken string of 70+ years of Keynesian fiscal policy. In fact, small parts of the Keynesian fiscal policy might have been the cause of this financial crisis. Additionally, regardless of whether it was the cause, Keynesian fiscal policy has robbed America of the flexibility it needs to address this problem.

Hopefully, this crisis will be the final nail in the coffin of Keynesian fiscal policy. However, that is unlikely. Instead, America is likely to see a rapid expansion of Keynesian fiscal policy.

Update: Apparently, he is an economist, and a very accomplished one at that. Which makes his defense of Keynes bizarre.

A warning

Taxing the rich, while politically popular, is not very wise. It has adverse economic effects. In normal times, those effects are minor, and it would be wise of Republicans to spend their political capital trying to rid the economy of other laws and regulations that hamper the economy more than high tax rates on the wealthy. However, these are not normal times. Potentially, the most devastating thing the Democrats could do if they get unchecked power is to excessively raise taxes on the wealthy.

The wealthy may may consider the new taxes. Next, they might consider the financial condition of the United States. And then, they might consider the burden of additional taxes they will be expected to bear in the future. And then, they might consider that they have to wealth necessary to migrate. After all this careful consideration, they might decide that the financially wise thing to do is emigrate. If they do it in large numbers, it would be economically devastating to America.

Every Man and Nation for himself

The root cause of the financial crisis is that private entities have come to believe that the inherent risk of their assets is higher than they had previously estimated. An increase in the perceived risk lowers the expected value of the asset. In essence, wealth has been destroyed simply because private entities perceive an increased risk to their assets. The way to solve the crisis is to help private entities lower their perception of the inherent risk of their assets. Unfortunately, chaotic self interest will almost certainly increase the perceived inherent risk of assets:

Iceland's prime minister, Geir Haarde, warned last week that it was now "every country for itself." This smacks of the financial autarchy that characterized defaulters in the financial crisis in Asia in the late 1990s. Similarly, when Argentina defaulted on its debt in 2001-'02, politicians there faced enormous pressure to change the rule of law to benefit domestic property holders over foreigners, and they changed the bankruptcy law to give local debtors the upper hand. In Indonesia and Russia after the crises of 1998, local enterprises and banks took the opportunity of the confusion to grab property, then found ways to ensure that courts sided with them.

Update: This article explains the point I was trying to make above about how value of wealth is lost.

Cut taxes

Greg Mankiw writes:

There is broad agreement among economists that what the financial system needs right now is not only an injection of liquidity but also a recapitalization....

The question for the moment is, How can we get capital back into the
financial system?

All economist should hate the payroll tax. Therefore, as a free market solution, economist should advocate aboloshing the payroll tax as a means of getting capital back into the financial system. It would not go directly into the financial system, but it would definetly free up capital for the financial system. It also might have the added benefit of addressing one of the fundamental causes of the crisis (i.e., falling home prices). Additionally, economist should advocate that the government cut income taxes as much as possible (while adding a small consumption tax for those who pay no income tax). Cutting taxes would add capital to the financial system, but many might be oppossed to cutting taxes for the following reasons:

• Taxes can not be cut without an act of Congress.
• The seriousness of the situation may not allow the time that is need to implement tax cuts.
• The lost tax revenue would add to the deficit.
• The capital added to the economy would not flow directly to the financial system.

Nonetheless, the payroll tax is one of the most economic inefficient taxes this nation has to bear. If this crisis can be used to get rid of it, economist should jump at the opportunity.

Spread the truth

Every American needs to know the truth about our economic crisis. I stole this video from Ace of Spades (I hope he approves and understands).

The truth will set you free

Ace of Spades writes:

Jay Cost, by the way, disagrees with me and thinks that McCain might as well "pee into the wind" as attempt to deflect blame from Republicans when it comes to a banking crisis. He suggests just hitting Obama on Ayers and Wright.

I say: Um, okay, can we not try all three?

Ace is right and Jay Cost is wrong. If Republicans act like they are to blame, the American people will assume that they are to blame. Republicans must argue forcefully for the truth (i.e., Democrats caused this fiasco).

Update: More than this election is at stake. If Republicans cede the economic argument to the Democrats, for the next 20 to 30 years, George W Bush will be used against Republican candidates for President the way Herbert Hoover was used. The only way to prevent this, is tell the truth and hope the American people are smart enough to see the truth.

Democratic Economic Incompetence

Glenn Johnson of the AP quotes Barney Frank as saying:

Republican criticism of Democrats over the nation's housing crisis is a veiled attack on the poor that's racially motivated...

Republicans should respond that:

• They are not attacking the poor or minorities.
• Poor and minorities are just as much a victim of Democratic incompetence as all Americans are.
• Democrats attempted to further the "interests of the poor and minorities" at the expense of business.
• Those attempts produced nothing for the poor or minorities, but has created a dire financial crisis for America.
• If the American people choose to give more political control to the Democratic party, the financial crisis will only get worse.
• The choice is America's to make, but it can only make an informed choice if Republicans honestly speak about the causes (The Democratic Party's bureaucratic socialist incompetent ideology) of the crisis.

via Power Line

Post Bailout Politics

Paul Mirengoff at Power Line provides John Boehner statement on the bailout:

The passage of this flawed but necessary bill is not cause for celebration.

The financial crisis is not a failure of the free-market system. It is a failure of a broken Washington, and a government culture that allowed executives at Fannie Mae and Freddie Mac and other firms to run amok, ultimately imperiling our nation’s economy. For years Republicans warned of this danger and advocated reform of these government-sponsored enterprises. And for years such reforms were thwarted by legislators with deep political ties to the worst offenders, putting the companies’ interests ahead of the interests of our country.

House Republicans stood on principle throughout this process. We secured numerous reforms on behalf of American taxpayers, such as raising the FDIC insurance cap, the SEC’s change to mark-to-market rules for certain assets that have worsened the credit crisis, and an insurance program that forces Wall Street to bear a financial burden in the rescue package. Republicans also were successful in stripping from the original Paulson-Democrat bailout plan of its special-interest earmarks for trial lawyers, labor bosses, and thinly-veiled political organizations like ACORN. This significantly improved legislation is much stronger than the initial Paulson plan and protects the interests of families, seniors, small businesses, and all taxpayers.

John Boehner is right. Hopefully, Republicans and conservatives will be able to unite behind this truth and get the American people to understand that the Republicans are working to create wealth, prosperity and security from terrorists while Democrats are working to create poverty, stagnation and uncertainty over America's ability to forcefully counter threats from terrorists.

No Bud on tap

I went out to dinner tonight. At the bar, they were out of Budweiser and a few other beers. I asked the bartender if they were having supply problems. He said they were.

It could be a sign that the restaurant was poorly managed, or it could be a sign of the financial distress the economy is under. Many companies use short term loans to finance their payrolls. With the credit crunch, this restaurant might have been short on supplies because their suppliers are trying to avoid the high interest rates by financing their operations through delaying the delivery of prepaid items.

The world will end tonight

I have had quite a few posts spelling out my position on the financial crisis. So when I read the following post by John Hinderacker at Power Line, I thought it was a fair critique and apropos. Especially the following sentiment:

The bill failed in the House on Monday, and the sky didn't fall. Those who predicted doom are a bit like the cartoon characters who don white robes and climb mountains carrying signs that say "the world will end tonight." They feel silly when the sun comes up the next morning.

It made me feel rather foolish. However, after reading the following post by Eric Posner at the Volokh Conspiracy, I am no longer felling like a "cartoon characters who don white robes and climb mountains carrying signs that say 'the world will end tonight'." The most relevant passage is as follows:

I ought to point out that, in any event, the Fed and Treasury have already made plans to go ahead and lend all the money that you thought Congress had voted down. They are doing so because Congress gave them the authority to do this in statutes enacted long ago, and charged them with the responsibility of resolving financial crises, which is exactly what they are trying to do. It is odd that the critics of the bill are not trying very hard to persuade the Fed to back off. What the Fed and Treasury want from the bailout bill but are not getting (so far) is additional political backing to help restore confidence in the financial markets. One might think that if all this money is going to be spent anyway, the case for the bill, which provides for additional tools and oversight, is rather strong.

Mark Levin on the bailout

Mark Levin has a face for Radio and a voice for writing (in spite of that awful voice, I understand his radio program does quite well). Mark thanks the House Republicans for their actions and says:

The liberal uses crises, real or manufactured, to expand the power of government at the expense of the individual and private property. He has spent, in earnest, 70 years evading the Constitution's limits on governmental power. If conservatives don't stand up to this, who will? If they don't offer serious alternatives that address the current circumstances AND defend the founding principles, who will?

Everything Mark says is true. The problem is that the House Republicans actions might make the crisis worse. If so, liberals will have a real/manufactured crisis "to expand the power of government at the expense of the individual and private property".

Mark to Market

John Hinderaker writes:

As the economic crisis has deepened over the last several weeks, a number of knowledgeable people have told me that the simplest thing the government could do that would have a significant effect on the availability of credit is to ease the "mark to market" rule. A couple of hours ago, the SEC did just that.

It is amazing that a decision a simple as this could have that much of an effect, but it is possible due to the money multiplier effect. Hopefully this will be enough to ease the credit crunch.

Regardless of the size of the effect, it makes you wonder what took them so long to make such a simple change.

Quote of the Day

Brett Arends writes:

The amount wiped off the American stock market on Monday alone was $1.3 trillion. That's almost twice as much as the theoretical price tag on the bill.

Many American taxpayers have already paid for this crisis through a loss of value in their retirement portfolios. The good news is that money can be regained, but it can only be recovered by solving the underlying problems. Otherwise, even more is at risk.

Princeton Economist Panel on the Financial Crisis

via Andrew Sullivan

In defense of elitism

Thomas Sowell writes:

The roots of this problem go back many years, but since the crisis to which all this led happened on George W. Bush's watch, that is enough for those who think in terms of talking points, without wanting to be confused by the facts.

People who think in terms of talking points generally considered themselves to be intellectual elites. The true intellectual elites are people such as Thomas Sowell who have actually studied the problem, know what the root causes are, and how to address them.

The Death of Capitalism

Daniel Gross writes:

Just as happened in 1932, it's possible that the Republicans' incompetence and bullheadedness in managing a financial crisis could lead to Democrats controlling both the White House and Congress.

This sentiment should strike fear in the heart of every free market advocate who reads it. Before the Great Depression, America had a classical free market economy. America was almost a libertarian utopia. After the Great Depression, America slowly became a socialized paternalistic big government nanny state.

If the financial crisis gets worse, and the Democratic party increases its political control, capitalism as we know it may not be able to survive. Saving capitalism should be the goal of all those who ideologically believe in free markets. If that means a bailout needs to be passed, then so be it.

Update: Megan McArdle says it better than I do:

It is worth noting, in answer to the libertarians who are wary of government intervention in the economy, that if there is a serious crash, we will get even more government intervention in the economy--and intervention that is much less to our liking. That cost has to be weighed in your assessment.

The right of eminent domain

Congress should make a list of individuals who are most responsible for this financial crisis (Franklin Raines, Jim Johnson, etc). Then through the right of eminent domain, they should seize all of their property. After taking their property, they should use it to purchase the illiquid assets that are causing the credit crunch. Then, they should give these illiquid assets back to the individuals who had their property seized.

Actually, congress probably should not do this, but it would be awesome if they did.

Rabble Rousing

Jonah Goldberg writes:

...if there ever has been a moment when reasonable men's hands itch for the pitchfork, this must surely be it. No one is blameless. No one is pure. Two decades of crapulence by the political class has been prologue to the era of coprophagy that is now upon us. It is crap sandwiches for as far as the eye can see.

I already have my pitchfork in hand. I just need to no where the mob is at so I can join the crowd.