The purpose of this blog is to explain in as simple a way possible three things. First the global economic situation that is affecting the developed world. The second will be the situation in Europe and third will be my own research on institutions. Although these may seem disjointed, I hope to clarify their connection and their relation to each other. I write this blog at the request of friends and family who seem a little confused at the explanations offered by economists. I will avoid using math as much possible to make my point and you are encouraged discuss and question anything I say.
To begin we must understand the situation which is unlike any other recession or downturn encountered before with the exception of Japan. There are some who go so far as to say that we are in a depression. The depravity of the Great Depression is not being felt largely due to the fact that what made that recession so bad were the mistakes made by the prevailing economists at the time; the classic example was the decision to contract the money supply (the amount of cash out there) which seemed prudent at the time but ended up being disastrous. Central banks and economists learned what not to do largely from the failure of policies in the Great Depression. However I will ask anyone who is desperate for a quick recovery to consider this, although the recession occurred in 2009, the financial crisis started in 2007. If the past five years have not been enough to convince you that this time things are different then I invite you to continue reading. Provided here will largely be a summarized version of the works of others, notably Paul Krugman, Richard Koo, Hyman Minsky, Steve Keen and many others.
Part of the reason of why I intend to avoid using math is to discuss aspects of human society and political economy that our equilibriums naively take for granted whether they be general, dynamic, static, etc. Suffice it to say that our math takes legal structure, political reform, cultural influences and many other non-market activities and entities as being devoted to efficient markets. The truth is that a market is constructed on top of all these things. The classic example came from Veblen who drew the comparison of markets to a sports game. Think of the many agents of supply, demand and the market daily operations as a soccer game in play. The legal structure, laws, etc (which economists call institutions) are the rules of that game. If you make a slight change in the rules you will change the way the game is played and its outcome. In the 1990s a series of banking de-regulations took place in the United States and other countries. The intent was to free banks from the constraints of cumbersome financial regulation. Before we begin to discuss the details I will offer a reason as to why some regulations are necessary.
Adam Smith once described the Discipline of Continuous Dealing as a market based behavior that would ensure that neither the buyer or the seller would seek to cheat the other. The idea was that a merchant would not sell a poorer quality good out of fear that the buyer would return it after using it and demand his money back. This situation would ultimately leave the seller with a useless good, no money gained and no long term customer which would decrease his future revenues. Although simple the assumptions made in this example do work for purchasing a consumer good like an apple or some other general good. The Discipline of Continuous Dealing breaks down when the products become complicated (meaning the consumer will only find out if he has been cheated too late) and when there is a separation between the business owners and the person doing the selling (like a corporation).
In a corporation the individual owners do not have unlimited liability, meaning when the costs of cheating exceed what the company can pay, the courts do not have any claim on the personal property of the owners to settle the debt owed to the persons who were cheated. As a result the company can go bankrupt but the owners’ private wealth is protected except for their lost investment in the company. So if an employee with no real stake in the company is selling something complicated where there is an opportunity to make a killing by cheating which will more than offset his future loss in income from being fired, the question is would he cheat? Well there is nothing enforcing him to be honest and if game theory (John Nash, some of you may have seen him portrayed by Russel Crowe in A Beautiful Mind) tells us anything then cheating is almost guaranteed to eventually happen and to continue after that. In effect discipline only works in a system where everybody knows everyone else (think of a rural village market) and there is no time bomb scenario where the adverse effects of cheating are felt long after the purchase. In a global world where the common knowledge of each other is limited and where time bombs do exist then discipline cannot and will not work. The next best thing is regulation. The purpose of regulating markets is to prevent this sort of cheating behavior from happening. Yes it will probably decrease the potential gains in the short run but in the long run its benefits are worth it.
In finance the point of regulation is to compartmentalize capital to prevent the costs of risk from spreading to other areas. The classic example is an oil tanker where oil is stored in several compartments to prevent two things. One is to prevent the momentum of the oil from building to the point where it capsizes the ship. The other is to ensure that if the hull is breached that not all the oil is spread into the surrounding ocean. Another way to think about it is quarantining a group of people that have been infected by a disease in order to prevent the spread of the illness to the rest of the population.
In modern economics Adam Smith’s concept of Discipline of Continuous Dealing is called Market Discipline. The idea behind Market Discipline is that professional groups will self regulate and police themselves and will black ball any cheaters. It was this idea that “ensured” that the markets would become too big to fail because Market Discipline would root out cheaters before the adverse costs became too large. In theory systematic shocks would be small and not large. The other argument created by market discipline is that there is no need for a third party to conduct policing since the corporations would do that themselves. As result it only made “sense” to gut regulatory bodies like the SEC in the United States since their efforts would not be needed. If you stop and think about the logic of this please understand that what happened was that the banks got bigger and the police force assigned to ensure that they were doing honest businesses was shrunk. In this scenario the potential cheater (thug) is too large for the police to take down. Add in the forces of globalization where some banks have larger operating budgets then that of small countries like Iceland then you have a really hazardous situation. This situation prevents penalization of hazardous cheating which is portrayed and sold to the world as risk.
There is a huge difference in what is uncertainty and hazardous behavior which in economics is lumped together as risk (if ever risk is discussed which is a rare event). Think of uncertainty as rolling a dice whereas hazardous behaviors are the actions of human beings. Hyman Minsky described a scenario where a prolonged period of stability would lead to risk-taking which would eventually implode and produce a state of instability. Imagine an individual agent deciding on a hazardous course of action since no one will notice it because everything is stable and the world should easily absorb the adverse consequences of his actions. This makes sense on the individual level however if a sizable number of people in this system start doing the same hazardous behavior then what they take for granted (which is the stability) will evaporate as a result of their collective actions.
In the case of the United States the “stability” was the “ever” increasing value of property and other assets. Add in an ability to “cheat” like selling massive amounts of sub-prime loans which fly under the radar of regulators and rating agencies because the collaterized debt agreements (CDOs) that they were lumped into are considered “safe” then you have a situation where only one of two things happen. Either the rating agencies and regulators find out before the situation gets out of hand and act appropriately or they don’t. In the event that they don’t then you have what is called an Asset Pricing Bubble fueled by debt. When you normally buy a house using a loan (not sub-prime) the money you owe the bank is the value of the house at purchase plus interest. If the value of the house suddenly drops you are still on the hook to the bank for the money you borrowed not the current value of the house. The burst of the Asset Pricing Bubble has created a situation where the aggregate value of everyone’s assets today (consumers, banks, businesses, governments, etc) is less than the amount of money they borrowed. This is called insolvency which is when the value of what you own is less than your debts. There are two insolvency scenarios. The first is bankruptcy, where you do not have the future income to make up the difference. The second is what is commonly known as being financially underwater since you do have the future cash-flow to make up that difference.
Imagine if you were a banker that was appointed to the position of CEO after your predecessor was sacked for almost bankrupting the organization, landing you with a bank that is “underwater”. Naturally you’d realize that the only thing to do in the interest of all the stakeholders (shareholders, workers, customers, debtors, etc) is to pay down the difference between how much you owe and the value of what you have. This process of paying down debt is called de-leveraging. This makes perfectly prudent sense on the individual level however problems occur if this becomes the mainstream private-enterprise policy (which it has) because everyone is underwater. Add in the fact that regular economic models taught in school do not allow for the existence of this situation, then you have everyone de-leveraging at a rate that takes a quick and rapid recovery for granted. The truth is that if de-leveraging becomes the popular policy then recovery and growth will be slow in coming and hard to maintain.
Labor market conditions and capital accumulation are symbiotic. Private-enterprise and governments need both capital and labor to do anything. Think of a carpenter and his tools, tools need the carpenter since they can’t use themselves and the carpenter needs his tools to do his work. Whether it is a hammer or an entire factory, workers cannot produce without the necessary capital. The role of financial capital is to finance the purchase of expensive “tools of the trade” that will take some time to pay off. The money used to finance these purchases generally comes from the savings of private households (think of the carpenter’s savings in the bank) and the retained profits of businesses (profits not paid out in dividends to the owners). As you can see workers need to earn a wage in order save which provides the financial industry with money that will be used to finance new business ventures. In a world that is de-leveraging on mass, capital accumulation is ground to halt. Which means that the labor market will experience higher levels and longer durations of unemployment as well as higher levels of underemployment (think of the a highly skilled carpenter peeling potatoes at McDonald’s).
Labor market conditions will not fully recover until the de-leveraging process is completed. This will take years. The question is what to do in order to speed up this process. Well the “classical” market correction method is to for deflation to happen. This is not a real option, deflation enriches the rich and greatly impoverishes anyone in debt. There are some like Koo, Krugman and a few others that state that the only way out is for the government to spend like crazy. The idea is that this would drive up the demand for money. This solution is economically feasible (with the exception of Portugal, Ireland, Greece, Spain and Italy) however this seems to be politically unfeasible (think of the Tea-party). The other option is for the lenders to relinquish part of their claims (which is currently going on in Greece) however this only happens if the lenders get a better deal in the long run or else they will demand higher interest rates for lending money in the future. I’d like to offer some hope but the best I can do right now is to offer clarity on the situation. I will be following this up with a discussion on the Euro crisis. Although the problems in Europe constitutes a sovereign debt crisis, every such event follows a financial crisis which is what started in 2007. In essence the euro crisis is just another chapter in the fallout of the bursting of the Asset Pricing Bubble.
