Frozen In Time, The Wrong S-Curve

Frozen In Time, The Wrong S-Curve

By |2018-11-05T17:26:29+00:00November 5th, 2018|Currencies, Economy, Federal Reserve/Monetary Policy, Markets|

As usual, Paul Krugman starts out with a serious attempt at answers before detouring into his current profession. Dr. Krugman used to be an Economist, and a pretty good one too (for whatever that’s worth). Nowadays, he employs his New York Times column as a mouthpiece for really blatant politicking. It isn’t even so much an arm of the Democratic party as it is raw anti-Republican.

That’s too bad because by betraying these instincts he ends up doing so much disservice.

He wrote a column back in September titled Botching the Great Recession. The first part is actually serious analysis; the latter not so much. There was a panic and a big economic contraction, and this one was different from those before. He doesn’t do it, but Krugman comes close to putting quotes around “recession.”

Why was this one so different? It’s a question only some Economists have dared to try and answer. Dr. Krugman intrigues when he says it was the prior bubble. “The really big factor was the bursting of the housing bubble — of which the banking crisis was a symptom.” A lot of what he relies on to justify this view is faulty analysis, however.

Krugman agrees with folks like Ben Bernanke that officials performed admirably during 2008. They weren’t the ones who “botched” the Great “Recession”, apparently (spoiler: it was Republicans who focused on deficits, ruining any attempt at even bigger fiscal profligacy). His simple argument goes like this:

Rapid financial recovery did not, however, produce rapid recovery for the economy as a whole. As the same figure shows, unemployment stayed high for many years; we didn’t return to anything that felt remotely like full employment (leaving aside the question of whether we’re there even now) until late in Obama’s second term.

If Obama had gotten a bigger ARRA or even another one, then recovery had a chance. Rubbish.

The key to his equation hinges on “financial recovery.” In his view, as anyone else, the financial system was healed through the good work of our central bank. Therefore, if the financial system recovered but the economy did not it couldn’t have been the financial system at fault for lack of economic trend afterward. Double rubbish.

There are too many key pieces of evidence (a sample shown above) you have to totally ignore to make this determination. It largely rests on a logical fallacy, appeal to authority (the financial system was successfully dealt with because Ben Bernanke and Paul Krugman said so). And it is taken in isolation, meaning that the panic in 2008 wasn’t a US event alone. The US central bank isn’t the only one that has been struggling to figure out the sudden and synchronized deviation from trend. You are quite obviously missing a whole lot if you refuse to account for a worldwide financial panic and the implications that might follow.

But all that relates to “why.” As far as “what”, this part is less contentious. Ben Bernanke didn’t like Krugman’s historical review one bit, but even bristling at the suggestion that there might have been more to be done he agrees on “what.” Writing at Brookings in September in response, the former Fed Chairman admits:

Indeed, research has found significant increases in precautionary savings during the financial crisis for both households and firms. In Krugman’s preferred IS-LM terminology, the panic induced a large downward shift in the IS curve.

Americans became more cautious as a result of the big 2008 contraction, whatever it was. Bernanke says nothing more could have been done, Krugman says the government should have been spending and spending and spending. Neither would have mattered because nobody gets 2008 right. If you botch the diagnosis there isn’t much chance you can figure out the correct prescription.

Again, the issue revolves around financial healing and not taking the official word for it.

According to the mainstream view, in the early 2000’s the dot-com bust and subsequent recession posed a unique challenge for policymakers. The Bush Administration delivered its version of stimulus, largely tax cuts, while Greenspan’s Fed unleashed “ultra-low” interest rates.

Spending per payroll, as shown above, never really deviated all that much from trend even though big things were going on. Actual spending would move slightly ahead of the baseline even before the last rate cut and remain above it until 2006 and the first indications of the housing bust.

Was Krugman right? Or, was it the S&P 500?

Everything depends on why the IS curve, or S-curve, shifted after 2008. Bernanke’s rebuttal to Krugman actually serves as a sufficient answer:

But a broad-based and violent financial panic, like the one that gripped the country a decade ago, will also affect the behavior of even firms and households not currently seeking new loans. For example, in a panic, any firm that relies on credit to finance its ongoing operations (such as major corporations that rely on commercial paper) or that might need credit in the near future will face strong incentives to conserve cash and increase precautionary savings.

Here’s where financial healing becomes everything. If firms and individuals believe differently about this factor than central bankers and former Economists turned political pundits, they might continue to act in the same fashion long after the experts claim everything is fixed. Then the problem isn’t more stimulus or drug addicts, it’s the experts who don’t know things are still broken.

The answer to that one is very different; it means going back to Square One rather than doing more of the same, fiscal or monetary policies. It also accounts for the consistency in the aftermath, why despite the unemployment rate falling to less than 4% Americans and American businesses still aren’t acting like things are booming.

It becomes self-reinforcing over time; the more the Bernanke’s and Krugman’s say the financial system is fixed and healed and you know that it isn’t (this pertains more to businesses than maybe individuals) the more entrenched your pessimism (therefore liquidity preferences) becomes. You just know that central bankers aren’t going to help no matter what they might do because they don’t even think there is a problem anymore.

Defensiveness is actually prudent.

This is why Economists therefore central bankers spend so much time trying to manipulate expectations. They believe that if they can convince you that things are going to be good, whether they are today or not, you will begin acting that way. In terms of the S-curve, if their policies get you thinking that the world is recovering then it will shift from E to E’. The result of that shift is when workers spend more of their existing income, leading to more jobs, then even more incomes. It is the virtuous circle of every Keynesian textbook.

The last ten years prove that expectations manipulation just isn’t enough, stock prices or not, when it isn’t fully credible. Again, the difference is between the real landscape and what “experts” think of it. Bernanke says everything is fixed, but you can see that nothing is (especially for a fourth time recently). The attempted manipulation is thwarted before it can ever begin no matter how high share prices skyrocket; the idea in real economy terms just isn’t credible. No virtuous circle.

Not only that, most people employing honest analysis will realize Ben Bernanke has every incentive to say this (if he can convince everyone that the financial system is, in fact, healed whether it really is or not then a bunch of very uncomfortable questions never get asked).

This is why 2008 still matters, because we are still living in the painful aftermath. It matters for the months when Payroll Fridays are “perfect”, further obscuring and muddying everyone’s sense of actual economic circumstances. So long as we are stuck on E and have no idea why, or even that we are on E, there is no getting back to E’.

According to Bernanke, that’s already a foregone conclusion. He tried everything and it didn’t really work, therefore there was never any way to get back there.

Krugman says it’s the damn Republicans who won’t let the government spend.

They’re both wrong. E’ is right in front of us. We just need to go back and really understand 2008, and therefore the three or four decades before it. It was never about subprime mortgages. Or housing. It isn’t even about the United States. 

 

 

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