Monday, July 26, 2010

Two Thought Experiments

1: Suppose we take a good long 2-by-4 and nail it to the side of a barn, so that it sits at eye-level and sticks out 8 or 10 feet past the corner of the barn. So maybe your kids could do chin-ups on it.

Now take a piece of rope and tie it to a cinder block and hang it from the free end of the 2-by-4. Get another cinder block and do the same thing. Get some more -- do they still call them cinder blocks? -- and keep hangin'em the same way off the end of the 2-by-4.

After a while the 2-by-4 starts to bend a little bit. Don't worry about that. Just keep hangin' blocks off the end of it until the 2-by-4 snaps. Oh -- be sure you stay out of the way, so you don't get hurt. And the kids, too.

Okay, got the picture? I have a question for ya: Could ya see it comin'? Could you see trouble coming? Did you know that the 2-by-4 was going to break at some point? I think so. I think you knew. Maybe you didn't know how many cinder blocks the 2-by-4 would hold. But for sure you knew one of them would be the one that broke the camel's back, so to speak.

2: Okay, now another exercise: Take the economy and nail it to the side of the barn so it sticks out just like the 2-by-4, and hang a trillion dollars of debt off the end of it. Hang another trillion dollars of debt off the end of it, and another and another and another. Keep going... At some point, do you think the economy will snap like a 2-by-4? I bet it will. I bet you think it will, too.

Thing is, nobody knows how much debt the economy can support before it suddenly snaps. So the only way to find out is the hard way.

To me it's not so difficult. At some point the economy starts to bend, just like the 2-by-4 did. That would be a good time to stop adding more weight. Maybe, take some weight off. Simple enough, isn't it?

For the record, our economy started bending under the weight of debt in 1973.


Paul Krugman here links to a Financial Times article by Ken Rogoff, and proceeds to "differ" with Rogoff.

Comment number 11 following that post caught my eye:

Clearly, at *some* point, even in the U.S., debt levels would matter. Ken's main point in the FT is that debt crises happen in a non-linear way: everything is fine, as it was for the markets in 2006 and the first half of 2007, until suddenly, it wasn't anymore. Seems wiser, to me, to be conservative about where that level might be, especially since we can only make educated guesses about it.

I don't know whether stresses affect the 2-by-4 in a "non-linear" way. But I know the stresses are obvious for a good long time before the 2-by-4 snaps. So I don't think it's right to say "everything is fine... until suddenly, it wasn't anymore." Not for the 2-by-4, and not for the economy.

I would agree absolutely with the last sentence of Comment Eleven's excerpt: Seems wiser, to me, to be conservative about where that level might be, especially since we can only make educated guesses about it. At some point the economy starts to show stress. That's the sign that we must stop accumulating debt.

Unfortunately, one does not simply stop accumulating debt. One either struggles with balancing the budget for decades after the stresses appear, as we still struggle; or one discovers a better analysis of the problem, and develops solutions that work.


The Arthurian said...

Oh, my.

From The Debt-Deflation Theory of Great Depressions by Irving Fisher:

"8. There may be equilibrium which, though stable, is so delicately poised that, after departure from it beyond certain limits, instability ensues, just as, at first, a stick may bend under strain, ready all the time to bend back, until a certain point is reached, when it breaks."

Irving Fisher's stick is my two-by-four.

The Arthurian said...

Irving Fisher's instability is Hyman Minsky's instability.

The Arthurian said...

From The real effects of debt by Stephen G Cecchetti, M S Mohanty and Fabrizio Zampolli (2011):

"It is important to note that our finding of a threshold for the effects of public debt on growth does not imply that authorities should aim at stabilising their debt at this level. On the contrary, since governments never know when an extraordinary shock will hit, it is wise to aim at keeping debt at levels well below this threshold."

What I said, except not only public debt.

And, and, and, and why is high debt NOT considered to be a "shock"? The implication seems to be that at some underlying level, Cecchetti et al still think high debt is perfectly normal.