Grandiose Fantasies of Economists

From the Taipei Times, we have an economist J. Bradley Delong (Berkeley) writing: Three cures for three crises.

The third mode is like the second: A bursting bubble or bad news about future productivity or interest rates drives the fall in asset prices. But the fall is larger. Easing monetary policy won't solve this kind of crisis, because even moderately lower interest rates cannot boost asset prices enough to restore the financial system to solvency.

When this happens, governments have two options. First, they can simply nationalize the broken financial system and have the Treasury sort things out -- and reprivatize the functioning and solvent parts as rapidly as possible. Government is not the best form of organization of a financial system in the long term, and even in the short term it is not very good. It is merely the best organization available.

The second option is simply inflation. Yes, the financial system is insolvent, but it has nominal liabilities and either it or its borrowers have some real assets. Print enough money and boost the price level enough, and the insolvency problem goes away without the risks entailed by putting the government in the investment and commercial banking business.

The inflation may be severe, implying massive unjust redistributions and at least a temporary grave degradation in the price system's capacity to guide resource allocation. But even this is almost surely better than a depression.

Let me state it upfront. These economists are full of shit.

Before we talk about why they are full of shit, let me state the general position. In order to understand macro, you must first understand micro i.e. you need to understand how nuts and bolts work before you can start talking about rocket engines.

The theoretical position is correct. Print enough money and you will boost the nominal price level enough, and the insolvency problem goes away.

Unfortunately, that's not how it works in practice.

Firstly, the Fed doesn't "print" money. What it does do is lower the price of money below the market rate which has an effect similar to but not the same as printing money. This is an exceedingly critical point, and I cannot emphasize it enough.

What that means is that it cannot control the channel in which this money will flow. It could flow into commodities, or it could flow into absurd Internet ventures, or it could flow into gold. They have no control over where it goes.

Everyone with me so far?

Now, where the money goes is a matter of psychology. No banker or trader in their right mind is going to throw money at a clearly collapsing asset (which is what housing currently is.) You'd have to be borderline retarded to do so,

The bankers are in it for the money. They don't give a crap about what economists or central banks desire.

In fact, you can see it in the headlines. Wells Fargo now wants 25% down in California. Whether the Fed likes it or not, this is tightened credit for housing (which means they are balking at loaning money for a collapsing asset.)

In fact it is precisely this reason that no bubble in history has ever failed to collapse, inflation or no inflation, central banks be damned!

Now in order to "cushion" housing prices, the money would have to flow into wages because the borrowers need to make their monthly payment. Anybody who believes that wages will increase in the presence of China and India online also believes in the Tooth Fairy.

Even assuming the Tooth Fairy actually shows up to town, the wages would have to go up right now not 12-18 months later because the borrowers need to make their monthly nut now not 12-18 months later.

Theoretical economists don't worry about time lags. etc. Wave the wand and double the money supply. Yeah, OK.

In what time frame, sir? And what will the borrowers be doing while you're waving the wand?

Finally, we come to the coup de grâce. This is where micro trumps macro every single time.

The credit has been flowing into commodities. Oil at more than $100; wheat prices up 46% in two months. Food and fuel prices are already rising steeply.

The needs of an individual are clear. First air (which is free), then food and fuel (heating, getting to job.) Only after that do they need shelter, and clothing. Everything else may safely be classified as discretionary. (Note if you can't get to your job, you won't be making any money.)

Now, each household has a finite pot of money each month (and this pot will not be increasing as explained above.) If food and fuel costs increase, then the amount of money they can spend on the rest must go down. Since food and fuel are absolute necessities, there is less money left over for shelter. I leave it as any easy exercise to the reader to figure out what happens to home prices in that situation.

So while theoretically inflation solves the problem, it has absolutely no chance of doing so in practice. In fact, it is going to make house prices collapse faster i.e. it will actually have the perverse effect of doing the exact opposite of what is intended.

Put that in your pipes and smoke it, economists!