What in the world is liquidity?

For some reason every time I start my computer this page drops down as one of the most recent websites I've visited. It's a NY Times article from May 2nd, 2008. The headline is

Fed takes steps to add liquidity

Besides the confounding fact that it won't go away, this headline is significant for the remarkably ignorant use of the word 'liquidity.' Somehow, many people use the term liquidity when what they really mean is money. The suggestion is that by adding money, which is what the Fed technically does, they are by definition adding liquidity. So, as the Times headline shows, the money comes to get reported as liquidity.

The problem is, not all money is liquid money. That is, not all money is easy to get and trustworthy to lend. Under certain conditions money can be like that, but not always. So, yes, the Fed can just 'add' money, but no, it can't just 'add' liquidity. Not unilaterally anyway. Liquidity is created in time and context and requires on-the-level institutions and willing players. Plural. People interacting. More specifically, liquidity needs people interacting within an acceptably stable and understandable field of organized regulations. Credible and confident people, in other words, working within socially accepted parameters.

We don't have these conditions right now, and we will lack these kinds of people, at least in the near term, no matter what the Fed does. The question is whether high levels of liquidity can possibly return in the medium- and long-terms. If so, than we would do well to get our house in order and, through a little fiscal discipline, restore our seemingly natural state of credit-worthiness. If, on the other hand, conditions being as they might be, a return of liquidity simply isn't in the cards, we will need a whole new system of wealth-creation. In this case, economic growth will depend again on actually being productive.

In a way, what I am saying is a lot is riding on what we come to know about liquidity. Headlines like this, which tell me we can't even define our words let alone gain a semblance of control over them, make me less confident.

Schiller on a 'theory of the mind'

Robert Schiller is the current economist who, among economists, as far as I can tell, is the most committed to uncovering the social-psychological bases of the current financial crisis. Here he is, writing in the NY Times:

[F]orecasts based on a theory of mind are subject to egregious error. They cannot accurately predict the future. But the uncomfortable truth has to be that such forecasts need to be respected alongside econometric forecasts, which cannot reliably predict the future, either.

Systemic thinking

I see that Citigroup's stock value is up a hefty percentage today (though the number remains remarkably low -- around 2.24). This fact brings to my mind the following question: Is the government doing the right thing in propping up Citigroup so that it will survive?

Actually, I think it's better if I ask it this way: Is the government correct to think of certain organizations as vital to the survival of the system?

Or backing up even further, what 'system' is the government thinking about? What are the structural outlines of this system? The economists in the administration, as well as those many with blogs who argue so forcefully -- what basis do they use to think about systems?

To me this is a central question. The dominant view of economic thinking is to see social organization (e.g. 'the market') as consisting just about solely as a simple aggregate of individuals with more or less uniform rationalities. Assuming this gives economists significant privileges -- like the ability to sometimes predict future behavior from past behavior, for example. However, the notion that social organization is more than the sum of its individual parts is, to this point, still, like it or not, a central tenet of sociological, not economic thought.

Or let me put it this way. It is sociology, more specifically, social theory, in any case not economics, that provides the conceptual tools to make sense of social systems.

That's why I find myself wondering who the economists are relying on to make decisions with regard to a system. Are they reading social theory? I wonder, because I doubt we can succeed in re-constructing our economy as well as we are actually capable of re-constructing it, without a solid theoretical conception of the 'system' we are trying to re-construct.

Paul Krugman = Malcolm X

When I was in college I read a whole lot on Malcolm X. Much of it was about his complex relationship with, perhaps more accurately, to Martin Luther King, Jr (to my knowledge they met only once). I more than once came across a particular historical account in which Martin Luther King's successes were nonetheless seen to owe a significant debt to Malcolm. The point these writers made is that Malcolm X was so damn crazy he made MLK look, by comparison, much more acceptable in the eyes of established elites and skeptical publics.

I can't verify if it's a valid historical account, but I think of the notion lately when I read the economist Paul Krugman and his criticisms of President Obama. If MLK had Malcolm X, Obama seems to have Krugman, whose existence in the pages of the New York Times forcefully arguing for more, more, more demand-side redistributions of wealth -- not to mention his loud advocacy of temporary nationalizing four or five of the country's largest banks -- gives Obama a very public guy about whom the president can say to his conservative critics: If you think what I am demanding is unreasonable, you should recognize that Krugman's the alternative. Be glad you got me because I ain't like that.

Bernanke's words suggest 'too big to fail' is now accepted knowledge

Here is Federal Reserve chairman Bernanke, from a speech given to the Council on Foreign Relations, March 10. He is talking about the relationship of the largest banks to the stability of the entire system, and the 'imperative' to save these large-scale institutions, lest we face significant systemic ruin.

In a crisis, the authorities have strong incentives to prevent the failure of a large, highly interconnected financial firm, because of the risks such a failure would pose to the financial system and the broader economy. However, the belief of market participants that a particular firm is considered too big to fail has many undesirable effects. For instance, it reduces market discipline and encourages excessive risk-taking by the firm. It also provides an artificial incentive for firms to grow, in order to be perceived as too big to fail. And it creates an unlevel playing field with smaller firms, which may not be regarded as having implicit government support. Moreover, government rescues of too-big-to-fail firms can be costly to taxpayers, as we have seen recently. Indeed, in the present crisis, the too-big-to-fail issue has emerged as an enormous problem.

In the midst of this crisis, given the highly fragile state of financial markets and the global economy, government assistance to avoid the failures of major financial institutions has been necessary to avoid a further serious destabilization of the financial system, and our commitment to avoiding such a failure remains firm. Looking to the future, however, it is imperative that policymakers address this issue by better supervising systemically critical firms to prevent excessive risk-taking and by strengthening the resilience of the financial system to minimize the consequences when a large firm must be unwound.

Achieving more effective supervision of large and complex financial firms will require a number of actions. First, supervisors need to move vigorously--as we are already doing--to address the weaknesses at major financial institutions in capital adequacy, liquidity management, and risk management that have been revealed by the crisis. In particular, policymakers must insist that the large financial firms that they supervise be capable of monitoring and managing their risks in a timely manner and on an enterprise-wide basis. In that regard, the Federal Reserve has been looking carefully at risk-management practices at systemically important institutions to identify best practices, assess firms' performance, and require improvement where deficiencies are identified.3 Any firm whose failure would pose a systemic risk must receive especially close supervisory oversight of its risk-taking, risk management, and financial condition, and be held to high capital and liquidity standards.4 In light of the global reach and diversified operations of many large financial firms, international supervisors of banks, securities firms, and other financial institutions must collaborate and cooperate on these efforts.

Second, we must ensure a robust framework--both in law and practice--for consolidated supervision of all systemically important financial firms organized as holding companies. The consolidated supervisors must have clear authority to monitor and address safety and soundness concerns in all parts of the organization, not just the holding company. Broad-based application of the principle of consolidated supervision would also serve to eliminate gaps in oversight that would otherwise allow risk-taking to migrate from more-regulated to less-regulated sectors.

Third, looking beyond the current crisis, the United States also needs improved tools to allow the orderly resolution of a systemically important nonbank financial firm, including a mechanism to cover the costs of the resolution. In most cases, federal bankruptcy laws provide an appropriate framework for the resolution of nonbank financial institutions. However, this framework does not sufficiently protect the public's strong interest in ensuring the orderly resolution of nondepository financial institutions when a failure would pose substantial systemic risks. Improved resolution procedures for these firms would help reduce the too-big-to-fail problem by narrowing the range of circumstances that might be expected to prompt government intervention to keep the firm operating.

Developing appropriate resolution procedures for potentially systemic financial firms, including bank holding companies, is a complex and challenging task. Models do exist, though, including the process currently in place under the Federal Deposit Insurance Act (FDIA) for dealing with failing insured depository institutions and the framework established for Fannie Mae and Freddie Mac under the Housing and Economic Recovery Act of 2008. Both models allow a government agency to take control of a failing institution's operations and management, act as conservator or receiver for the institution, and establish a "bridge" institution to facilitate an orderly sale or liquidation of the firm. The authority to "bridge" a failing institution through a receivership to a new entity reduces the potential for market disruption while limiting moral hazard and mitigating any adverse impact of government intervention on market discipline.

The new resolution regime would need to be carefully crafted. For example, clear guidelines must define which firms could be subject to the alternative regime and the process for invoking that regime, analogous perhaps to the procedures for invoking the so-called systemic risk exception under the FDIA. In addition, given the global operations of many large and complex financial firms and the complex regulatory structures under which they operate, any new regime must be structured to work as seamlessly as possible with other domestic or foreign insolvency regimes that might apply to one or more parts of the consolidated organization.

Another word on Paul Krugman

Earlier I wrote a post and was kinda hard on Paul Krugman, saying his columns and blog posts are at heart political rather than scholarly exercises. I hold to that.

But I'll say, I do admire Mr. Krugman's ability to make forceful arguments extrapolating from data. Even when I disagree with him, and even if his arguments often appear to have mainly political ends, I must say he is as good as there is at articulating economic data in an interesting, useful, accessible way.

An example, from his column of today:

President Obama’s plan to stimulate the economy was “massive,” “giant,” “enormous.” So the American people were told, especially by TV news, during the run-up to the stimulus vote. Watching the news, you might have thought that the only question was whether the plan was too big, too ambitious.

Yet many economists, myself included, actually argued that the plan was too small and too cautious. The latest data confirm those worries — and suggest that the Obama administration’s economic policies are already falling behind the curve.

To see how bad the numbers are, consider this: The administration’s budget proposals, released less than two weeks ago, assumed an average unemployment rate of 8.1 percent for the whole of this year. In reality, unemployment hit that level in February — and it’s rising fast.

On one hand this argument is weak -- even in its entirety, it falls short of adequately acknowledging the political and cultural realities of the moment. It wasn't easy for Obama to get the stimulus he did. There are a lot of powerful headwinds against massive government spending of the sort that Obama just pushed through. More money for national defense? Easy. Demand-side redistribution of wealth through institutions of health, energy, and education? Not so easy.

But on the other hand, Mr. Krugman has a point -- as large as the stimulus was it might not fully meet the challenge of the contraction, at least not as soon as we might like. And he finds a perfect data-point to show it: The 8.1 percent unemployment that was supposed by the Obama administration to be the year's average is going to be passed by the end of March. This fact helps make the argument for much, much more stimulus somewhat compelling.

Obama and Krugman are interesting rivals. They seem to have an on-going debate that I will try to document.

'Imperatives'

“It is imperative that we continue to move with speed to help make housing more affordable and help arrest the damaging spiral in our housing markets,” said Timothy F. Geithner, the Treasury secretary, quoted here.

One of the under-analyzed words relating to the current economic problems is 'imperative.' It is being said that certain economic actions are 'imperative,' like continually saving AIG, and others are not, as when Lehman was allowed to fail. For a while it seemed reversing the housing downturn was not imperative, now we hear it is. How did this decision come about? Where did this notion of the imperative come from?

I have little doubt that, in a general sense, some parts of our economy are more important than other parts. My question is in the details. Do we have a good theoretical framework for actually knowing what is imperative and what is not? And imperative to what? To whom? For example, the government beliefs that led them to let Lehman fail, as of today, look dubious, according to, in any case, the very 'systemic risk' test the government is supposedly using to make its decisions. In other words, in hindsight, saving Lehman looks like it had been imperative, by the government's own approach, but the government let it fail anway. Are we making other similar mistakes?

I guess what I want to ask is: Who are the economists who have studied the concept of 'the imperative'? What knowledge is Sec. Geithner relying on?

Or let me put it this way: Where in all the theories of capitalism is there given such central importance to the notion of the imperative? I see the concept in functionalist sociology like that of Parsons and Habermas. But where else? You can't tell me the Secretary is reading Parsons, or Habermas. Maybe he should be. Who are the economists working on a theoretical conception of the imperative? Who does Geithner talk to and about, and who and what does he read, that is, when he's not making asinine tv on CNBC?

My hunch is that today's officials have no theoretical framework. They go case by case.

More from President Obama

I am hearing criticism of the President that his speech last night was short on 'details.' That's fine. It was. But I think the criticism misses the point. America can't actually claim to know its details right now. Until we see the consequences of Iraq, and find the actual market value of our troubled assets, the details of our economy and our political strength are in question. What Obama really has to say is about ideas: old ideas are dead and tried; new ideas are necessary and responsible.

For example, watching last night and now reading the transcript of his speech, I was struck by the extent he lectured America's political elites for their behavior the past few decades. Especially here:

Now, if we're honest with ourselves, we'll admit that for too long we have not always met these responsibilities, as a government or as a people. I say this not to lay blame or to look backwards, but because it is only by understanding how we arrived at this moment that we'll be able to lift ourselves out of this predicament.

The fact is, our economy did not fall into decline overnight. Nor did all of our problems begin when the housing market collapsed or the stock market sank.

We have known for decades that our survival depends on finding new sources of energy, yet we import more oil today than ever before.

The cost of health care eats up more and more of our savings each year, yet we keep delaying reform.

Our children will compete for jobs in a global economy that too many of our schools do not prepare them for.

And though all of these challenges went unsolved, we still managed to spend more money and pile up more debt, both as individuals and through our government, than ever before.

In other words, we have lived through an era where too often short-term gains were prized over long-term prosperity, where we failed to look beyond the next payment, the next quarter, or the next election.

A surplus became an excuse to transfer wealth to the wealthy instead of an opportunity to invest in our future. Regulations...

(APPLAUSE)

Regulations -- regulations were gutted for the sake of a quick profit at the expense of a healthy market. People bought homes they knew they couldn't afford from banks and lenders who pushed those bad loans anyway. And all the while, critical debates and difficult decisions were put off for some other time on some other day.

Well, that day of reckoning has arrived, and the time to take charge of our future is here.

Now is the time to act boldly and wisely, to not only revive this economy, but to build a new foundation for lasting prosperity.

--If I hear him right, his 'better' ideas are comprehensive reform of the way we burn energy, the way we take care of our health, and the way we educate.

--The GOP is in some trouble. It is steadily becoming accepted knowledge that, as Obama points out, these are, at the very least, the best ideas coming out of Washington in quite some time. And these ideas directly contradict the anti-planning ethos of the Republican Party.

--I look forward to his budget, which I believe is released on Thursday.

More from the 'Financial Responsibility Summit': President Obama's remarks

My administration came into office one month ago in the depths of an economic crisis unlike any that we've seen in generations. And we recognize that we needed to act boldly and decisively and quickly and that's precisely what we did. Within our first 30 days in office, we passed the most sweeping economic recovery package in history, to create or save 3.5 million new jobs, provide relief to struggling families, and lay the foundation for long-term growth and prosperity.

. . . .

Contrary to the prevailing wisdom in Washington these past few years, we cannot simply spend as we please and defer the consequences to the next budget, the next administration or the next generation.

We are paying the price for these deficits right now. In 2008 alone, we paid $250 billion in interest on our debt: One in every 10 taxpayer dollars. That is more than three times what we spend on education that year; more than seven times what we spent on V.A. health care.

. . . .

We'll start by being honest with ourselves about the magnitude of our deficits. . . .

. . . the budget I will introduce later this week will look ahead 10 years, and will include a full and honest accounting of the money we plan to spend and the deficits we will likely incur.

And:

We're not going to be able to fall back into the same old habits, and make the same inexcusable mistakes, the repeated failure to act as our economy spiraled deeper into crisis.

All nice sentiment, but he did not mention once the actual means of stabilizing the national economy: greater tax revenue, higher interest rates, and fewer imports. He talks about cutting unnecessary programs and 'pay as you go' legislation, but those aren't the problem, and he knows it. That said, it's difficult for the public to be an insider to President Obama's real thoughts. It's hard to have access to the real truth as elites see it; their public language always feels pressure to conform to accepted narratives. I thought his remarks today, as technically imprecise as they were, exacerbated this problem and further divided the President from his audience.

The whole of his remarks begin here.

Vice President Biden introducing economist Mark Zandi at today's 'financial responsibility' summit

Our first speaker today will be Dr. Mark Zandi. Dr. Zandi is the chief economist and co-founder of Moody's Economic -- excuse me, Moody's Economy.com -- where he directs the company's research and consulting activities. He's one of the best big picture guys in the business. His most recent book, "Financial Shock," was widely praised for its lucid explanation of the housing bust. What's less well known about Mark is that he donated the royalties from that book to a fund to invest in low-wealth neighborhoods. He's also an economic adviser to John McCain's campaign. And I'm glad he's -- he's here with us today.

. . . . p> And as I understand it, we're going to -- I'm now turning the program over to -- to Mark, if I'm not mistaken.

Mark, welcome.

(APPLAUSE)

MR. ZANDI: Thank you for that very kind introduction. It was greatly appreciated, and the opportunity to speak this afternoon at this important meeting, to address the nation's daunting long-term fiscal challenges.

I'll make two broad points in my remarks.

First, the Obama administration has inherited the worst fiscal situation in the nation's modern economic history.

Read the whole transcript here.

Remember Phil Gramm?

He was the one this most recent summer who called the current mess a "mental recession" and said that Americans are a "nation of whiners." He was a big part of Candidate McCain's economic team. Then he said those things and was seemingly banished. Well, here he is writing an op-ed for the WSJ. I found this interesting:

The debate about the cause of the current crisis in our financial markets is important because the reforms implemented by Congress will be profoundly affected by what people believe caused the crisis.

I point out this passage because there is a real consistency of worldview between it and his 'mental recession' comments. The consistency lies in Gramm's emphasis on psychology as a driving force of economic outcomes. A 'mental recession' is nothing other than an event that plays out in peoples' heads (in a socialized way). And now he contends that,

the reforms implemented by Congress will be profoundly affected by what people believe . . .

Three responses. (1) Say what you want about Mr. Gramm, he is trying to use cutting-edge economic theory that questions rather than assumes the nature of human behavior. (2) It strikes me as odd that a man as aware as he of the psychological underpinnings of economic processes would be so blind to how others would think about being called 'whiners.' And (3), Gramm's virulently political strand included, like it or not economic theory is changing to meet new realities. Even free-marketeer Phil Gramm is a sociologist.

Three strong pillars of economics knowledge

It is more popular today than I can remember to say something like the state of economics knowledge is in crisis. But this statement does not ring entirely true. There are at least three forms of economics knowledge that are still growing, vibrant, increasingly helpful at explaining experience.

These are --

1. Institutional economics

2. Behavioral economics

3. Economic sociology

Executive pay caps and 'incentives'

--Moments ago a personality on CNBC, who, judging by his statements, considers himself a faithful adherent to free-market economic theory, argued that recent executive pay packages had nothing to do with the crisis we are in. Right or wrong, this statement is remarkable as a blatant contradiction of free-market economic theory, which sets as one of its most important tenets that incentives matter.

If the enormous pay incentives weren't motivating behavior and leading to the growth of 2002-2007, how would economic theory explain their existence? This way: The pay either stimulated behavior, or was a significant inefficiency in the market. So the pay is culpable in the crisis, or, if it isn't, it needs to be changed anyway.

In sum, here was one of the faithful, god bless him, trying to argue in favor of the free-market, and it took undercutting one of the main pillars of free-market thinking to do so.

--The study of economics faces a moment of crisis. This moment is in stark contrast to the few smooth decades for economic theory that got us here. As this body of knowledge works itself out, we should remember that the goal should be to improve our understanding of incentives, not all of a sudden pretend they don't matter. Our current age includes a whole lot of money, and, at least theoretically, a whole lot of incentive as a result.

--It strikes me as a good research project to put together a picture of the social institutions that shape 'incentives.' What the hell are they? Where do they come from? How do they get us to do things? How do they change? A couple sociologists (at least one who studies politics economics, and another who is versed in stats and economic sociology) could sort out the question of incentives.

--Here are a few of the institutions that I'd begin with:

1. The Federal Reserve and Treasury

Actions: Print money and make debt, expand the money supply, in sum, make money exceptionally available, create an incentive?

2. The government

Actions: Use rhetoric like 'small government,' push for tax cuts and shape ideology, cut taxes and manipulate fiscal outcomes, create incentive?

3. Family, education, and media

Actions: house opinions and create the public sphere of ideas, entrench communicative habits and create knowledge, market truths, create an environment conducive to consumption, create an incentive?

4. Social-psychology

Actions: Individuals interpret environment and develop conception of self-interests, a broader socialized mind develops in concert with public sphere of ideas in which individuals participate, individuals in return internalize and/or reject the incentives that are communicated, a social mind of rough consensus and certain deviation emerge around the notion of money as an accepted stimulant of behavior

Monetary risk

It looks like tomorrow President Obama will sign into law the stimulus bill. It is a historic bill -- a meaningful re-distribution of wealth that contrasts sharply with the previous administration's approach to distributing wealth, especially their initial tax cuts. About this plan, the other day I wrote:

The argument against Obama's plan is that it exacerbates monetary risk.

The words 'monetary risk' represent a need for new categories of language and knowledge. The recent era of easy money was little concerned with monetary risk. Instead, the country has proceeded as if our monetary regime is beyond reproach -- we were, we are, the world's printing press, the thinking went, and so we can, if we choose to, create more and more debt. Or, as Dick Cheney, put it, "Reagan proved deficits don't matter."

The current contraction is ending this knowledge. Events are showing that America's ability to print money and finance huge debts is not endless.

It is time the words 'monetary risk' get bandied about more seriously when economists, social scientists, journalists, and businessmen and women talk. The sentiment behind the words should be in the minds of elites and publics alike.

But to this point, our ideas have not yet acclimated to this new knowledge, as this stimulus bill includes tax cuts instead of a way to pay for it.

That said, I still am for the stimulus.

Brad DeLong on the 'end of monetarism' and the limits of money-supply expansion

After World War II, laissez-faire economists had a big intellectual problem: the Great Depression. How could you argue for dismantling the post-WW II social insurance states and returning to the small-government laissez-faire of the past when that past contained the Great Depression?

. . . .

[Milton] Friedman proposed that with one minor, technocratic adjustment a largely unregulated free-market would work just fine. That adjustment? The government had to control the "money supply" and keep it growing at a steady, constant rate--no matter what. Since money was what people used to pay for their spending, a smoothly-growing money supply meant a smoothly-growing flow of spending and, hence, no depressions, Great or otherwise. In Friedman's view, if the task of monetary stabilization could be accomplished via technocratic manipulations by a non-political central bank, there would be no need for much of the apparatus of the post-World War II social insurance state.

In the 1950s Friedman's doctrines were considered way out there. But his Keynesian adversaries overreached, and claimed that clever governments could maintain price stability and a high-pressure economy with "full" (rather than merely "normal") employment. By the 1970s, it was clear they were wrong. Since then, advocates of expanded social democracy have been on the retreat more often than on the advance. By the 1990s, even left-of-center politicians had come to respect central bankers' mastery of the money supply, giving them a wide berth.

The power of Friedman’s theory was, in part, rhetorical. "Keep the money supply growing smoothly" sounds like it means to keep the presses in the Bureau of Engraving and Printing rolling at a constant pace, printing out a steady flow of pictures of George Washington. But that is not how "money supply" actually works. In economic reality, "money supply" means not just cash money but also credit entries the Federal Reserve has made in commercial banks' accounts at the Fed; plus all the credit entries commercial banks have made in households' and businesses' checking accounts; plus savings account balances; plus (usually) money market mutual-fund balances; plus (sometimes) trade credit and the ceilings between credit card limits and consumers' current balances.

No central banker controls all these vast and varied sluices of the money supply – at least not in economic reality. When banks and businesses and households get scared and cautious and feel poor, they take steps to shrink the economic reality that is the "money supply." Businesses extend less trade credit. Credit card companies cut off cards and reduce ceilings. Banks call in loans and then take no steps to replace the deposits extinguished by the loan pay-downs. Without a single bureaucrat making a single decision to slow down a single printing press, the money supply shrinks—disastrously in episodes like the Great Depression. Thus in emergencies, to say that all the central bank has to do is to keep the money supply growing smoothly is very like saying that all the captain of the Titanic has to do is to keep the deck of the ship level.

For the past eighteen months the collective central banks of the world have been trying as hard as they can to keep the deck of the ship level. Traditionally, central banks boost the money supply by buying government bonds from the Treasury for cash. Buying government bonds for cash cuts the supply of bonds the private sector can acquire, boosting their price while lowering interest rates, making businesses more eager to spend to expand and making asset holders feel richer and thus more eager to spend to consume.

The central banks and finance ministries of the world have purchased so many government bonds for cash that they have pushed the prices of short-term government bonds up as high as they can possibly go. With interest rates practically zero, there is no extra interest return to be gained in the short run from bonds. Yet it has not been enough.

So increasingly over the past year, the central ministries of the globe have taken extra measures: they have guaranteed debts, they have partially or completely nationalized banks, they have forced weak institutions to merge with stronger ones, they have expanded their balance sheets to an extraordinary extent. And yet this, too, has not been enough.

So now the central bankers have thrown up their hands, and asked for help to stimulate spending through tax cuts and government expenditures. Because they have run out of means to "keep the money supply growing smoothly."

Today, we have reached the end of the line for the Chicago view of financial deregulation. Friedman thought (a) that the central bank could exercise enough influence over the money supply to effectively control it, and (b) that banks and other financial intermediaries would be regulated tightly enough that what is now happening would be impossible. But he never resolved the tension between his view that banks need controls and the Chicago view that business must be unfettered.

Monetarism may well make a comeback -- as a doctrine that is good enough for normal times. For in normal times "keep the money supply growing smoothly" does appear to be a relatively easy task, a minor adjustment to laissez-faire that can be performed by a small number of qualified technocrats. Unfortunately, not all times are normal.

Source.

I am for the stimulus

Four thoughts:

--I support President Obama's so-called 'stimulus' plan as a government-spending program that is intended to re-distribute wealth to the middle-class. I support it for the purpose of (1) enhancing the productive job market, and (2) re-growing the most dependable consumer class in the world, one of America's most important assets.

--I believe the supply-side experiment is over. It met the objectives it laid out for itself: grow the economy and keep inflation in check. It did that. But new conditions call for a new experiment.

--The stimulus and the TARP are not the new experiment, they are transitions toward it. The new experiment is, to the best of my reading, still open-ended.

--I keep close in mind that President Obama has Paul Volcker sitting next to him. For some reason. That reason strikes me as obvious: to sooner or later unleash him. As soon as we turn the contraction to growth, if even slightly, what would be the plan if not to unleash him? That means higher interest rates, and higher tax rates, to bring down the deficit and strengthen the dollar. I don't think the 'deficits don't matter' approach that we see right now will last beyond the contraction. In fact, I think the approach will rapidly swing the other way, via Volcker.

The problem of wealth re-distribution

In this country, when men and women with any publicity talk about economics, the idea of 'wealth re-distribution' is pre-conditionally rejected. No serious commentator can be thought to be a re-distributionist. So, except for Republicans who use the word to accuse their Democratic counterparts, nobody brings the idea up. As a result we never talk about the idea in a serious manner. We talk about economics as technical, but the distribution of wealth as ideological. Public communication continues to be dominated by a dogmatic -- rather than an empirical -- approach to wealth. This is a problem for two reasons.

1. It reduces confidence in the efficiency of the market. Under some conditions, it is simply possible that re-distributive policies have their technical merit. The supply-siders know this: much of their credibility stems from their willingness to say precisely how their distribution of wealth -- tax cuts -- leads to efficient markets: by increasing the incentive of economic actors to generate wealth. The demand-siders tend instead to use a moral, justice-based approach. They are not as proficient in explaining how their spending programs will lead to growth. Right now President Obama should be explaining how the bill will re-create -- 're-grow' -- a vibrant middle-class of consumers. He should not call it stimulus, but a major growth package.

2. The big reason this narrow communication pattern is a problem is because it's false. Any activity by a givernment impacts the distribution of wealth. They print the money. They determine the interest rate at which they give it away. They choose who they give it to. Tax cuts, tax increases, spending programs, spending cuts -- these are all major factors in who gets their hands on America's wealth. The evil of re-distribution is a false myth we tell ourselves. Re-distribution is a banal reality. I have no problem with myths. Every society holds them. But what good are they if they ring so damn untrue?

Finally, it is remarkably brazen that at this moment we hear cries of redistribution. Are we not aware that America's wealth is now socially owned? That this massive nationalization -- we still don't quite call it that -- happened during a Republican administration? I can't help but think this American form of socialism is here to stay for a while. The need to admit the fact of re-distribution, and tackle it in a sensible and technical matter, is as great as ever.

Quote of the day: William James

The truth of an idea is not a stagnant property inherent in it. Truth happens to an idea. It becomes true, is made true by events. Its verity is in fact an event, a process: the process namely of its verifying itself, its veri-fication. Its validity is the process of its valid-ation.

William James, Pragmatism, 1907. As printed in Pragmatism: The Classic Writings, edited by H.S. Thayer.

If we think of free-market ideology as truth, we can say this truth was socially verified with the fall of the Soviet Union in the late eighties and early nineties. Following that event, the dominance of the free-market ethos became highly entrenched as recognized knowledge. But now, due to more recent events, the verity of the free-market is coming back into question. It is up to the human mind, the social mind, to decide again whether the truth of the free-market fits the reality of the events before our eyes.

In this way the debt crisis, the credit crisis, the housing crisis -- all these crises are simply, and complexly, a crisis of knowledge, wherein the truth we thought we knew about economic reality fails to meet the challenge of present-moment events.

The turmoil we are experiencing is the fact that we seem to be facing a situation in which our old truths are just that -- old. We must develop new truths, new knowledge, and thus new reality.

This is the pragmatist theory of how social change comes about -- when our mind recognizes that the truths we tell each other don't fit the fact of reality. We then develop new truths or new realities, or both.

Economists confounded by the social fact of 'confidence'

Here is Robert Schiller writing in yesterday's WSJ:

President Obama is urging Congress to pass an $825 billion stimulus package as soon as possible. But even that may not be enough to stabilize the economy, since it fails to take into account the downward spiral of animal spirits that is underway and may continue to worsen.

The term "animal spirits," popularized by John Maynard Keynes in his 1936 book "The General Theory of Employment, Interest and Money," is related to consumer or business confidence, but it means more than that. It refers also to the sense of trust we have in each other, our sense of fairness in economic dealings, and our sense of the extent of corruption and bad faith. When animal spirits are on ebb, consumers do not want to spend and businesses do not want to make capital expenditures or hire people.

Here is John Cochrane, dismissing 'confidence' as a tenet of economics knowledge:

[Some] say that we should have a fiscal stimulus to “give people confidence,” even if we have neither theory nor evidence that it will work. This astonishingly paternalistic argument was tried once with the TARP. Nobody could say how it would work in any way that made sense, but it was supposed to be important do to something grand to give people “confidence.” You see how that worked out. Public prayer would work better and cost a lot less. Seriously, as social scientists, economists don’t have any special expertise to prescribe what intrinsically meaningless gestures will and will not give “confidence,” so there is no reason for anyone to listen to our opinions on that score.

Truth is, both Schiller and Cochran are right: 'confidence' -- or whatever you want to call the social-psychological category -- is both central to being able to understand or explain economic processes, as Mr. Schiller argues, AND peripheral to present-day economics theory, models, and concepts, as Mr. Cochran argues.

Indeed, to gain insight into 'confidence' -- and I agree with Mr. Schiller, via Keynes, that economics should try to gain such insight -- economists would have to be willing to turn to sociologists, whose well-established categories like legitimacy, power, authority, habit, the lifeworld, social structure, and interaction could help the economist learn a thing or two about the variabilities of human behavior and thought.

I read economists as much or more than I read sociologists. I value their knowledge. But I have a working hypothesis that their theories are not up to the task of understanding present problems. The chief culprit is their disinterest in the human mind and its social context. I also sense that economics practice suffers from a certain level of arrogance. This arrogance will not suit them well in a period like the one we are all of sudden in -- in which economics needs help from the very fields of knowledge they define themselves against.

Creating a basis for credible economic growth

For some time now, I have been constructing a two-part (hypo)thesis about the future of the US economy. I am still putting together the pieces, and learning as much as I can, but here it is: About a year and a half ago, after three years of significant study, I began to say out loud to people willing to hear things like this, that within the next five to ten years the dollar would face a day of significant reckoning. I began to believe this because the massive growth of GDP and expansion of the money supply the past three decades have been, as I began to see it, the result of illegitimate and unsustainable systemic actions by the country's elite economic actors. In short, we have borrowed too much relative to how much we have produced. So our economic growth has lacked credibility: the reality does not match the myths we have told ourselves, namely, that our 'fundamentals were sound.'. As soon as, my hypothesis went, the relevant participants in the world economy recognized this -- say, the American government, the Chinese government, American investors, foreign investors -- major change would then be upon us in terms of the dollar and Americans' purchasing power.

Let me explain some of the details, as I see them. Our growth the past three decades has been disproportionately greater than the production of valuable goods, services, or knowledge that should be its basis. And our money-supply expansion has not been the result of greater gold reserves. Rather, it is the result of international political power, the 'right' to disproportionately shape the world's exchange rates, and massively unbalancec capital flows toward US bond markets. In short, we've been living on credit because the rest of the world -- especially China -- have been financing and re-financing our debt.

As such, our growth and monetary actions have been the result of a massive credit-grab unprecedented in the history of mankind.

This is why the relationship between the US and China strikes me as so important, and why I so often write about it in this space. China is the reason we've been able to engage in this credit-grab. Without China we likely wouldn't have been able to so immensely leverage our capital and expand our bottom lines. Therefore, if the relationship between the US and China changes, or is changing, and I think it is, this is a major event. The reason: China's willingness to grow its surplus, constrain its population's standard of living, and finance the US dollar through long-term treasury purchases is the single biggest basis of American growth during this era. As soon as China changes these actions, the American economy will return to a level of wealth more proportionate to the value we add to the world economy through our production of goods, services, and knowledge. We will still be wealthy, but not nearly like we've experienced the past decade. My sense is that America is slowly returning to a more production-based economy, while China will become more consumption-oriented.

This will put the world's economy in a better balance, and America's economic growth -- once we can get it started again -- will be more legitimate, sustainable, and equally distributed within our population. That is, our growth will again be credible. But our standard of living will recede for the next decade or two. How much it will recece, I don't know. We'll have to wait and see.

As a result of all this, the most important thing we can do is recognize that credibility is a multilateral construct. Credibility exists in the eye of the beholder. We cannot force other people around the world to interpret the US economy as legitimate. We cannot force them to behave in a certain way. We can't forever expect the rest of the world to interpret their own economic interests as financing ours. Especially if we continue to act irresponsibly with bad loans and even worse wars. We must create an economy that, once again, inspires confidence in the minds of others. Only after we have created this credibility, will our standard of living begin to return levels we've grown accustomed to.

To this end, we should immediately begin to build the social insitutions it will take to create the goods, services, and knowledge that the whole world craves, and that the US is in the best position to produce. Less finance, more practical creativity.