Thursday, February 04, 2010
Business cycles: hot on the trail!
In the new York Times, Paul Krugman speculates as to why in the recent "unpleasantness" Canada has largely avoided the banking crisis that the United States suffers.
In the course of his discussion Krugman observes that "It wasn’t interest rate policy. Many commentators have blamed the Federal Reserve for the financial crisis, claiming that the Fed created a disastrous bubble by keeping interest rates too low for too long. But Canadian interest rates have tracked U.S. rates quite closely, so it seems that low rates aren’t enough by themselves to produce a financial crisis."
This is largely nonsense for several reasons (Canada didn't track U.S. rates closely, for one). But for a while I've also been increasingly doubtful that low interest rates "by themselves" are the culprit. Artificially low rates start a fire. The accelerant that makes it run wild is opportunism, corruption. William Black has documented this "running wild" in America's S&L crisis, and we've had something similar with the current financial crisis. Low rates are a big part of the "criminogenic environment" that government helps establish (that's my thesis, not Black's), but not a full account of the story.
Mises himself observed this opportunism during the post-WWI inflation in Austria, but chose to speak only on what he saw as the pure economics of interest rate policy...a mistake, I think, because both corruption and interest rate policy appear to be common to historical boom-bust cycles.
Maybe it's time that we combine Austrian economics and criminology. A coordinated investigation of Treasury, Fed, and Goldman, anyone?
As for other factors in the difference between Canada and America, this graph from The Economist a few weeks back suggests one factor:
Blogger doesn't allow the img tag in comments, so all I can do is link to the graph.
Canada went from being a big-government nation to a relatively small-government nation over the previous decade. America went the other way (thank Bush and Rove's Big-Government Conservatism). And as for the UK - well, no wonder we are screwed. This graph should be on every Conservative poster at the forthcoming election, but of course it won't be, because they were too busy trying not to be the "nasty party" and promising to "share the proceeds of growth" to do their job as opposition.
The importance of the financial services within the economy is another obvious factor. And did Canada have the equivalent of Fannie Mae, Freddie Mac and government instructions to expand home-loans to those who couldn't afford it? Or did they suffer less of a property bubble (a major factor in the expansion of broad money)? Did Canadian interest rates need to be as high as American and British rates clearly did but weren't?
And the role of energy in both blowing the bubble and pricking it has been underestimated. The USA is an energy-glutton whose economy will be dented when energy prices go above a tipping point that we discovered for the first (but probably not the last) time. Canada is exceptionally resource-rich and does very nicely, thank you, out of energy price-spikes.
Criminality implies illegality. Were many of the suspect activities that fuelled the bubble really illegal, or is the problem that some important things that ought to be illegal are currently legal? And if it's the latter, do we blame those who abuse the rules or those who make them?
Opportunist, yes, but we need opportunists. In other circumstances, they are called entrepreneurs. The problem arises when the institutional framework does not constrain opportunism within rules that ensure the opportunism acts in the public interest. We have been inundated with ineffective rules targeting means or ends, when what we need are a few clear and draconian rules that constrain behaviour, so that individual initiative and social cooperation are harnessed in the interests of society, without pre-judging which outcomes are in the interests of society. In particular, people have to be fully exposed to the consequences of their choices. Bodes well, then...
1. Strictly speaking, it's changes in money *and credit* -- i.e. it's interest rates per se, rather than the stock of money, that is fundamental. Fractional reserve is a mechanism by which rates are artificially lowered. FR gives central banks more leverage for manipulating rates, but FR per se wasn't the problem here, nor do I think it a fundamentally separate issue.
2. Big government spending (especially deficit spending) indeed lies at the heart of this mess. Central banking and monetary policy are ultimately tools of govt finance. I don't think there's a direct causal link between growing deficits and central bank policy, but the deficits create an incentive for looser policy.
3. Freddie, Fannie, etc. are additional ways in which government expands credit beyond mere interest rate manipulation. In particular, by creating a secondary market for MBS, esp. those based on subprime and other non-AAA mortgages, gov't helped create the bubble. I don't know Canada's situation, but this wasn't germane to critiquing Krugman's conclusion.
Energy: I think it's a red herring here.
Criminality: yes, I suspect there's plenty of that; or more to the point, William Black (the former S&L investigator) suspects this. And without question, plenty of things that were done should be illegal. Since Goldman Sachs et al. have infiltrated Treasury, and it is ex-GS people making the rules, the rules after consulting with GS et al., it seems to me a clear case of regulatory capture, or mercantilism. E.g. when GS asked for and was allowed to change to a bank holding company so that it could obtain cheap credit & FDIC protection, it was permitted an exception to the rules that permitted it to retain trading operations usually denied to those using taxpayer-insured funds. Later, when GS found even the rules constraining, it was allowed to switch bank to a financial holding company. Asking whether to blame those who create the rules or those who abuse them misses the point that this is a cooperative effort. I emphasize Goldman b/c it seems to be the worst offender, but it's not unique.
Final paragraph: this is Baumol's unproductive and destructive entrepreneurship. The entrepreneur who specializes in shaping and gaming the institutions, in accounting trickery that generates phony profits and big bonuses, in risking bankruptcy to earn bailouts isn't simply passively responding to the rules. And I think that this, combined with the standard Austrian theory of false signals from artificially reduced interest rates, is the main story behind financial bubbles.
Cock-up usually trumps conspiracy, so I always look for an explanation that doesn't rely on evil powers. But perhaps Goldmans really are that toxic. If so, what should be done about it?
In the case of some UK rent-seeking oligopolies (e.g. in the energy and construction-materials markets), I believe they should be disintegrated (vertically-integrated companies broken into their component parts to prevent the erection of barriers to entry and reduce their influence on government, and obligatory asset-sale rather than being sold as a going concern if they go into administration). Obama and our Conservatives are suggesting something similar for the banks, I believe, but would that deal with an organisation like Goldmans?
I don't think, though, that "conspiracy" vs. cock-up are the alternatives. They seem to omit fraud and schemes that approach fraud, but really aren't conspiracy in the popular sense (but probably constitute civil or even criminal conspiracy).
I think that the environment of systematic interest rate manipulation and debt financed consumption favor the explosion of this kind of opportunism.
I basically agree, as I think the only alternatives in the near future are draconian regulations or endless crises and bailouts at taxpayer expense.
By the way, "cock-up or conspiracy" is just a phrase to distinguish between something accidental or something deliberate. Fraud fits into the colloquial meaning of "conspiracy" in the phrase.