November 22, 2010
The Cure is the Disease
In an age of high-velocity information, creative monetary "policy" can only do mischief.
Think about this: the biggest variable -- the biggest source of uncertainty -- in our economy right now is what Fed monetary policy will be. Fortunes will be made, and the value of American capital will rise and fall, based on good or bad guesses about what the Fed will do with the money supply and how that will affect interest rates. Why, in a democracy, should that be the case?
The monetarists certainly made an adequate case that the money supply can disrupt the economy, with disastrous consequences. The de-chartering of the Second Bank of the United States and the subsequent chaos in American banking are generally seen as the main causes of the panic of 1837 and one of the longest and deepest depressions in our history. The California and Alaska gold rushes set off periods of inflation.
But in the past, there were also real factors that contributed to the business cycle, to periods of boom and periods of bust. Classically, guessing wrong about consumers' preferences, entrepreneurs built up inventories that could not be sold and had to be "worked off" -- a cycle of overproduction and then underproduction.
Often, these fundamental problems with the economy were the result of monetary policy -- a cycle of currency inflation and deflation. But there were fundamental problems -- there were actual inventories that couldn't be sold.
Today, it seems to me, the business cycle exists exclusively in the financial system. The critical fact that has changed things is the quantum improvement in the availability of information. With just-in-time inventory management, the problem of holding goods that cannot be sold has significantly deflated (as it were). Today, you can order a book from Amazon that is printed directly in response to your individual order. Indeed, many "goods" can now be provided at almost no marginal cost -- digital goods like music or books or information. In this context, gambling on huge capital costs (like building a new steel mill or car factory), with consequent increases in business cycle risk, has become a less significant factor in the real economy.
The Keynesian revolution represented a rejection of the "classical" notion that the solution to recession-related unemployment is a downward adjustment in wage demands -- that in a general deflation, everything costs less, so workers can work for less. Lower wages equal more employment. Problem solved.
I take it that the Keynesian "insight" was that in view of the stickiness of wage preferences, classical theory, however elegant, just doesn't work in the real world. As Wikipedia describes it:
[N]ominal wages are often said to be sticky in the short run. Market forces may reduce the real value of labour in an industry, but wages will tend to remain at previous levels in the short run. This can be due to institutional factors such as price regulations, legal contractual commitments (e.g. office leases and employment contracts), labour unions, human stubbornness, or self-interest. Stickiness normally applies in one direction. For example, a variable that is "sticky downward" will be reluctant to drop even if conditions dictate that it should.
As Keynes famously said, "In the long run, we'll all be dead." All that matters is the short run.
Given the current velocity of information, Keynes's insight is hopelessly outmoded. His and his followers' advocacy of monetary "pump-priming" and the artificial creation of demand via government spending depends on a high level of ignorance on the part of actual market participants. When the government floods the market with money, actual market participants actually have to feel stimulated -- they have to feel that there really is sufficient wealth in the economy, and hence demand for their goods, to rehire, start up the (old) assembly line, and produce more.
Unfortunately, as, for instance, Dan Rather found out, we don't live in ignorance anymore. We all know what's happening. We drive down the street and see a bunch of guys in orange re-paving a perfectly good road and we think -- uh-oh -- there's more money being wasted. And less money that we have to spend on things we actually need. We definitely don't feel stimulated. Sorry, Mr. President.
In this context, the Fed decides to drive down interest rates by inflating the currency. Great idea! In the 1920s and '30s, that strategy would work. Because nobody knew what was going on. But wait a second. According to the Wall Street Journal, "Bucking the Federal Reserve's efforts to push interest rates lower, investors are selling off U.S. government debt, driving rates in many cases to their highest levels in more than three months."
Why? Because, in our information rich world, formerly sticky things have become ... unstuck. If you tell us you are going to inflate the currency, we are going to take measures to negate any effect you think you might achieve. That is how markets work.
In criticizing the proliferation of complex derivatives, Rick Bookstaber cites a lesson from engineering -- that complex systems are inherently fragile. "Complexity is one of the demons that makes our financial markets crisis prone."
The hugest element of complexity in our current financial system is one of the easiest to eliminate: Fed monetary policy. I repeat what I said at the beginning. Why, in a democracy, where we are supposed to be more or less left alone to make our own economic decisions, should the most critical factor in those decisions be guessing what the Fed is going to do?
The game is over. Just get out of the way.