Saturday, January 1, 2011

No Good Ending

Googlin "concentration of wealth over time" brought me to Skewed Wealth Distribution and the Roots of the Economic Crisis by David Barber, who writes:

Recently, Robert Shiller, a professor of economics at Yale University, penned a New York Times article warning that the fear of a double dip recession might actually bring on the dreaded event. “Ultimately,” Professor Shiller warned, “the risk resides largely in social psychology.”

As someone who is not a professional economist I do not know whether Professor Shiller’s views are typical of his field. What I do know is that while “social psychology” may have had some small role as a causal factor in the Crash of ’08, it was the actual structure of the American and world economies which brought on the crisis. And if in fact we enter a second round of this Crash, it will not stem from what Dr. Shiller calls a “weakness and vulnerability of confidence,” but will result from the same structural elements of our economy as those that brought on the “first dip.”

Agreed. The problem with the economy is not that confidence is low. Rather, confidence is low because of problems with the economy.

Part of the problem with the economy is that policymakers misunderstand policy, and therefore cannot fix the problem. And the longer the problem remains unresolved, the worse confidence gets. This problem has lasted so long now that economists like Shiller are losing confidence in monetary and fiscal policy. The great irony is that they point to the falling confidence of others as the source of the problem.

Confidence remained good for a long time after the economy went bad. It's easy to see which came first. The one that came later cannot be the cause. Barber is right; Shiller is wrong.

That said, let's look at David Barber's very next sentence:

American society’s fantastically skewed distribution of wealth stands as one of the main structural fault lines underpinning the Crash.

I wouldn't argue the point. But like the decline of confidence, the skewing of the distribution of wealth arose after the economic problem arose. And the skewing was no accident. It was part of a policy created to improve the economy. At least, it was if the skewing of wealth is anything like the skewing of income.

Mr. Barber, while he uses the word wealth, is actually talking of income in his post. He goes on to say that, because of the skewing, people started using more debt as a substitute for income:

And so debt has had to sustain our market economy: the more skewed the distribution of wealth has grown over time, the more frantically has the economy been forced to create a growing array of consumer debt mechanisms—subprime mortgages, payday loans, more and more intricately structured credit card debt—in order simply to maintain its functioning.

Again, I wouldn't argue the point. We have increased our use of credit largely to prevent a decline in our living standards. "Simply to maintain," as Barber says.

But again, which came first? The growth of debt came first. We called it credit-use then, and we grew it because it grew the economy. But we let private-sector debt accumulate until it overpowered all the benefit of credit-use. That was when the economy went into decline. That was 1974.

After the economy went into decline, policymakers began doing more to encourage the growth of credit-use. They mis-read the warnings our economy was giving us. They thought using even more credit -- and accumulating even more debt -- would fix the problem.

Following that line of reasoning, they ultimately encouraged the rise of "a growing array of consumer debt mechanisms—subprime mortgages, payday loans, more and more intricately structured credit card debt." In hindsight, we can see this was the wrong policy.

We must also observe that debt came first. Accumulating debt was the problem that caused our economy to falter, which led to a new spate of policies encouraging the use of credit, which made the accumulation of debt even bigger. It was insanity. It was a policy that could have no good ending.


Bigvic said...

I would caution not to completely dismiss social psychology from this but on the whole you are right about the causal relationship here. But I must take issue with two points here.

First, you point out that debt increased first and was the policy chosen to continue growing the economy, but my issue with that is that if the economy continually needed debt financing to artificially maintain a growth rate then there has to be a more fundamental structural problem at the heart of all this. I agree with your whole causal model from your previous post, but I think you are missing why growth and standards of living have to be maintained through debt financing.

Similarly, my second issue is that you argue in hindsight, policy makers chose the wrong policies. I take issue with this because the whole purpose of policy making in a democracy is to get the policy maker reelected. Therefore if you create growth, and therefore jobs, and you maintain people's standards of living, they do not care if you do it artificially, they will reward you. "In the long run we are all dead." Obviously this presents a structural problem, (I must admit, I am a long run person) but the problem here is with the concept of policy making, and not the policies. The policies are clearly wrong for the long run, but the role of policy making is for the short run as it will always be in a democracy.

Don't let my two issues with your post fool you into thinking that I don't like this post. To be honest, I find this blog to be one of the most interesting blogs I have ever read and I think you do great job here (hopefully that doesn't come off as patronizing).

The Arthurian said...

Hey, Bigvic, good to see you... Thanks... And I am always looking to improve my analysis, so...

...if the economy continually needed debt financing to artificially maintain a growth rate then there has to be a more fundamental structural problem at the heart of all this...

Could be, but I don't see it. Most of our "structural" problems arose since Reaganomics was put in place. Our problem in the 1970s was inflation, or stagflation. Our problem in the '60s was civil rights, and in the '50s the Red Scare -- not (macro)economic problems.

The fundamental problem, to me, is that policymakers had it wrong. They thought they could stop inflation by taking money out of circulation. And they thought they could grow the economy by getting us to use more credit.

To touch on your second issue: Wouldn't it have been better if policymakers created growth and jobs and improved living standards by making sure we had money to spend, rather than credit to use?

Oh, for a very good telling of economic history (but not causalities) see paragraphs 4 and 6 thru 12 or so, at the BillyBlog thin-brain post.

I think you are missing why growth and standards of living have to be maintained through debt financing.

Sounds like you are waiting for me to ask. Okay: Why do growth and living standards have to be maintained through debt financing?

The Arthurian said...

Oh oh oh oh oh
The fundamental problem to which you refer is that accumulating private-sector debt reached too high a level by the late 1960s or early '70s, and it started inhibiting growth.

Since then of course, our policy of encouraging credit-use only made the problem worse.

But the underlying cause all along has been that policymakers always think they need to restrict the quantity of money in circulation and encourage additional credit-use.

Bigvic said...

The underlying cause that I was referring to is the cause for why "private-sector debt reached too high a level by the late 1960s or early '70s, and it started inhibiting growth." I think the answer to that question lies at the heart of what happened here. I understand that Reaganomic policies created a structural problem, but Reaganomics didn't grow out of a vacuum, what precipitated this dynamic change in the first place. That is what I was hoping you could answer. What caused this debt to build up to such critical mass at that specific time as opposed to any other time? Is this just some economic fluke, a case of the wrong place wrong time perfect storm that some people took advantage to change the paradigm? Or is this just a product of growth, that the further you grow, the further your growth rate approaches zero and we haven't learned to cope with that?

The Arthurian said...

Gotcha, Vic. Bear with me. Your questions and prompts help me focus.

The reason accumulating debt inhibited growth in the 1970s is the same reason it inhibits growth now: Debt is the residue of credit-use.

Credit-use -- think of it as "extra spending" in the economy -- helps the economy grow. But it doesn't come free. Credit-use creates debt, and debt has to be paid back.

Paying back debt creates an "equal and opposite" drag on the economy, which must eventually balance out against the boost created by credit-use. It all comes down to a matter of proportions: The amount of new credit put to use over the course of a year, versus the accumulation of debt which is the result of having put credit to use in years past.

In an economy with little or no debt, the existing debt creates little or no drag for the economy. That drag can easily be be offset by just a little credit-use. But as the years go by, the little uses of credit accumulate into a substantial debt. To offset the drag of that accumulated debt, the new uses of credit must become larger -- and larger yet, to obtain growth from that new credit-use.

There is a snowball effect: greater and greater amounts of new credit use are required to offset the harmful effect of accumulating debt.

Meanwhile, policymakers believe that we need credit for growth. So, when an unknown factor (for example, the accumulation of debt) hinders growth, policymakers respond by encouraging even greater uses of credit.

And since we have no policy to encourage accelerated repayment of debt, our debt has accumulated to perverse and unnatural proportions.

Well, I put enough time into this comment that I can't tell if it makes any sense at all.