Babylon is Fallen, Fallen

On the recommendation of a friend at work, I have read The Return of Depression Economics by Paul Krugman, winner of the Nobel Prize in Economics. The book is not an economics text. It is a well written narrative for the educated layman describing a number of economic crises, including causes, governmental responses, and lessons learned. Krugman is a Keynesian and politically liberal. Economists like to consider themselves dispassionate scientists using statistical methodologies to describe and predict the behavior of socio-economic man. Unfortunately, human behavior is not as predictable as that of objects in a Newtonian physics experiment.

Currently there are three major schools of economists. Each of them believes they have an inside track on the truth. Representatives of two of the schools, Keynesian during liberal Democratic administrations and Monetarists during neo-conservative Republican administrations, have had an opportunity to put their hands on the economic control systems of our nation. The Austrian school of economics, favored by libertarians and extreme conservatives, has not yet had a chance to operate the throttle of the nation’s economic engine. I have taken the two introductory courses in economics required in engineering school. I have read a number of popular books by economists (similar to this one) and over the years I have read various statements and critiques of economic theories in the press. I am not an economist, nor do I wish to become an economist. However, the actions they are allowed to take by our politicians have real consequences in the material world. Sometimes these actions are accompanied by unexpected second order effects. I think economists, in spite of their considerable mathematical prowess, are closer to theologians than scientists. I have friends who minister in a variety of different denominations. Each of them is a serious educated Christian. Each of them has encyclopedic knowledge of the scriptures and has read mountains of commentaries and theological masterworks by the great geniuses of the Faith. If I were to put any three of them together in a cage at the same time, I expect the results would be outlawed by Congress as a barbaric blood sport.

Krugman, as a Keynesian, favors direct governmental intervention in the economy. During boom times characterized by irresponsible exuberance, they contend the government should raise taxes and cut spending. During recessions or depressions they believe the government should lower taxes, increase government spending, and fire up the printing presses down at the Department of Treasury. To explain how this works in practice, Krugman presents the model of a babysitting Co-Op. In this particular example one piece of babysitting script is equal to one hour of babysitting services. The participating parents earn script by babysitting and expend script when they want a night on the town. At one point the Co-Op experienced what is called a liquidity trap. No one wanted to expend their babysitting script and the whole thing locked up. The managers of the Co-Op hit upon the Keynesian solution of dumping new pieces of babysitting script into the system. With plenty of script in circulation, the parents once again began to go out rather than hoarding their resources. There is a fatal flaw in this example. There was no devaluation of the currency. One piece of babysitting script was still worth one hour of babysitting services. In our economy the value of the dollar has been intentionally and systematically devalued by the Federal Reserve Bank at the rate of 2% to 3% per year. Over time this adds up. In the 1930s a loaf of quality bread sold for 10 cents. Today the same loaf of bread goes for about $3.50. In the 1930s an ounce of gold was valued at $30.00, today $1,100. Lord John Maynard Keynes, the author’s hero, once observed, “The best way to destroy the capitalist system is to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”

In describing a number of different crises prior to our current problems triggered by the collapse of the shadow banking system, derivatives, and subprime mortgages, Krugman does a pretty good job explaining what happened in terms I could understand. However, I was never satisfied with his explanations of why, how to apply the lessons learned to the next crisis, or what any of it had to do with our current economic quagmire. Part of the problem is probably my lack of knowledge in the field of theoretical economics.

Of course Krugman was very much in favor of the bank bailout undertaken by the Bush administration in October 2008 and the subsequent bailouts and stimulus packages offered by the Obama administration. As Milton Friedman observed in a previous crisis, “We are all Keynesians now.” Krugman seems somewhat puzzled that the actions taken by government, while stopping or at least postponing a complete collapse of the world’s economy have not yet had the desired positive effects of increasing available credit and lowering unemployment.

His prescription is, of course, more government expenditures and increased regulation of previously unregulated financial entities. To some degree, his faith in Lord Maynard Keynes seems to have blinded him to some rather simple truths.

In an analysis by Richard Young, it is observed that the Federal Reserve Bank is loaning commercial banks money at essentially zero interest rate. The banks can then use this money to buy Treasury notes that pay 3.5%. Young states, “At leverage of 10 to 1, a position in five year Treasuries would net a bank a 20% return on equity with zero credit risk. Why bother lending money to a borrower who may default when you can make 20% in Treasuries?” In an even more simplistic analysis the financial blogger, Mish Shedlock, observes the banks that have been recently and severely burned are in no mood to make more bad loans to individuals or corporations with dubious credit ratings. Responsible citizens with good credit ratings are concerned with the possibility of job loss or the collapse of their 401-K accounts and are in no mood to borrow money except in the most extreme cases. Finally, due to the collapse of the residential housing market, in many cases it is cheaper to rent than to own a primary residence. Why risk foreclosure, a ruined credit rating, and a loss of principal when renting allows you to save money and the freedom to pack your bags and move on to another city in a financial emergency.

No corporation in the private sector is going to hire a new employee unless they are pretty darn certain the presence of that new employee will generate more in profits than in costs. Government stimulus packages have a place in emergency action but they will never create stable wealth producing tax revenue generating jobs. When all the bridges are repaired and all the pot holes have been filled, then what? Not only will those jobs disappear but someone will have to pay back the money that has been borrowed by the government. There are only two ways to repay that debt, taxes or inflation. Neither is a desirable option. Although it is outside the scope of Krugman’s book, I would also add that many of the programs and policies currently working their way through Congress are terrifying to the very businessmen, particularly the small businessmen, who create most of the new jobs in the United States. One of my friends runs a small business. He is a stone mason who is a master artisan rather than a construction worker. Even though he has a wonderful reputation in his industry and has plenty of contracts in this bad economy, he knows that if socialized medicine in its current form is signed into law, he will have to layoff a number of his employees. There is just no way he could pass the additional cost on to his customers.

The aspect of this book that I found most informative and I must say, humbling, is my discovery of just how interconnected and unpredictable the world’s economies have become. A country doing the right things and minding its own business can see its economy destroyed by the unintended second order effects of an action taken in another part of the world. In some cases the very virtuous behavior that creates wealth will attract speculators who will profit from the destruction of something of value that took years to build. The world’s economy is such a complex and nonlinear system I don’t see how economists think they can control it.

Krugman does admit economists face a “trilemma” that seems close to an insolvable problem. He states, “Think of it this way. There are three things that macroeconomic managers want for their economies. They want discretion in monetary policy so that they can fight recessions and curb inflation. They want stable exchange rates so that businesses are not faced with too much uncertainty. And they want to leave international businesses free—in particular, to all people to exchange money however they like—in order to get out of the private sector’s way.”

I am all in favor of regulating things like the shadow banking system that have created our current problems and I do believe that the excesses of the past decade will be regulated in the future. However, I believe the problems we ultimately face, lie not in regulation of banks or the lack of regulation, but in the human heart. No regulations can prevent ingenious greedy men and women from finding ways to circumvent the intention of the law.

Jeremiah 17: 9

The heart is deceitful above all things, and desperately wicked: who can know it?