Wednesday, September 17, 2008

Is the sky really falling?

I've already been asked why I hold such a drastic view of the economy. And why believe over-the-top "America has gone socialist" Nouriel Roubini? Other analysts, e.g. financial economist Brian Westbury, argue that the crisis will soon be over - Westbury argues that the financial debacle will be limited to a segment of the finance markets, and won't spill over into the non-real estate real economy.

Good questions. I think it's worth asking whether I might not be wrong, because...

First, betting on disaster is usually a losing proposition. We're hard-wired to worry, because panic helps trigger the fight-or-flight response that can keep us alive. But it also makes us prone to false alarms. Second, the U.S. economy is big and resilient, with enormous productive capacity and entrepreneurial "talent." Predictions of imminent economic disaster have been around longer than I have, and are almost always wrong. Third, the mere fact that Roubini's predicted some things correctly doesn't mean he's right about others. Maybe it's simply been random luck, like the Royal Head Flipper.*

These are serious objections, and deserve some thought. After all, what if they are right?

Let's take them on in reverse order. Why do I tend to believe Roubini? It's not simply that "well, he's been right so far." Success in predicting really ought not be taken as an indicator of future success, because only successful predictors will come to our attention; hence we have no way of distinguishing between a Royal Head Flipper and someone with genuine insight. I tend to believe Roubini's analysis because I have followed his arguments for quite some time. His theory, his description of the mechanisms behind financial crises, matches well with what I understand about these. His "model" makes sense to me, and I think is a good description of the way the world works. His predictions are, in part, logical consequences of his theory. But ultimately, it's "my" theory, in that this is an area to which I've devoted a fair amount of study, and in my view Roubini has the story basically correct. Conclusion: my belief is based in the best theory I can find.

But this isn't sufficient. One can believe in malinivestment business cycle theories and still see the current situation as only a blip; this seems to be Westbury's position (he too takes an "Austrian" view of the Fed's role in this). Why do I think the magnitude of the problem is so great, especially in light of the enormous potential of the U.S. economy? Here I frankly cannot judge on my own. How big the problem, and how many markets it affects, is an empirical question, one best answered by someone who studies it as a full time job - thus certainly not me. OTOH, the RGE Monitor assembles and reports a substantial amount of research on this issue, and it suggests that, contrary to Westbury, the problem is very big. Furthermore, lurking in the background is likelihood of exploding federal budget deficits. Hardly anyone seems to pay any attention to this, but every serious study projects unsustainable levels of debt; I don't think there's any controversy here. Conclusion: the magnitude of the financial problems is big enough to entail substantial economic harm.

OK, so much for points two and three. But what about point one, particularly in light of unforeseen contingencies? What things *haven't* I looked at that might mitigate or obviate all this? If they are really unforeseen, "unknown unknowns" (did anyone notice that Paul Krugman mentioned these in the 14 September op-ed I referenced two posts ago?), I won't be able to identify them. But where could my "train wreck" story itself derail? If I have the theory right, and the magnitude, then... unexpected sources of economic growth? I suppose that's one. I can't think of much else. I keep coming back to doubts about the magnitude, but I don't see why such doubts would be reasonable. So on this point, I can only say that I don't think this is mere panic on my part.

So yes, I'm saying "the sky is falling!" And I agree that it seems a strange and doubtful thing to be doing. But it's not a viewpoint I've come to recently, and there's reasoning behind it. I can only hope I'm wildly wrong.


* Footnote: What's the Royal Head Flipper? A king decided to find the person in his kingdom who had the greatest skill at flipping a coin and getting "heads." So he assembled all his 32,768 subjects, gave each a fair coin, and they flipped. The 16,384 who flipped "heads" then flipped again, and 8,192 obtained a second "heads." These then flipped a third time... and after 15 flips only two were left. These two flipped, and one got "heads." He was immediately proclaimed the "Royal Head Flipper." Question for reader: on the next flip, what was his chance of obtaining "tails?"


Or should I use the same math as the guvmint?

If the govermen are flipping the coin, it's 0%, since they'll steal or lose the coin.
Probably not, since any coin the government will be flipping will be worthless anyway.

No, no, you're thinking of the houses that were flipped.

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