The Bailout -by Josh

Friday, September 26, 2008 – 11:26 AM
The Bailout
The other day I received an e-mail from my uncle asking for my thoughts on the economic crisis and the proposed bailout. Below is his e-mail followed by my response.

———

Josh,

Maybe you can help me. I am trying to apply an aging physicist brain to the current economic situation and I could use some help.

Admitted bias upfront, I tend to see things more positively by reflex.

Premise 1
Inflation is caused by an increase in the “money supply” without a corresponding increase in goods and services causing more money to chase the unchanged supply of goods thereby increasing the price.

Premise 2
The value of “bad” mortgages was part of the “money supply” when the mortgages were good
and therefore marketable. Now that the mortgages are “bad” and unsellable they are no longer
part of the “money supply”, or have radically decreased in value, thus the “money supply” has decreased as a result.

Question 1
If the government prints money to e. g. buy the illiquid mortgages, (for less than 100 cents on the $)is it not just replacing the money which the illiquidity of the mortgages removed, and thus is “neutral” effect on the “money supply”?

Premise 3
The root of the problem is the decline in housing prices which “removes” wealth from the system,
and is thus “deflationary”.

Question 2
Does not the effect of Premise 3 give the treasury room to “print money” to balance it without
increasing the overall money supply and thus being neutral on the inflation front.

Sincerely wanting to understand,

Unc

P.S. Henry Paulson is: A. a socialist B. an idiot C. Someone whose career evidences a solid understanding of the system, and who is a believer in “capitalism”. D. Other (Please specify)

———-

Hey Unc,

I’ve had a chance to think about your questions, and while I don’t have any conclusive answers, I do have some thoughts that might help flesh out the picture a bit.

For starters, I will observe that your premises/conclusions are based on an oversimplification that is typical of most mainstream discussion of economics – i.e. considering economic phenomena in terms of broad homogeneous categories rather than as aggregations of an infinitude of discrete and varied elements. For example, when the government measures GDP, no distinction is made between a dollar spent on a TV-set and a dollar spent on education, although obviously their effects on the economy are very different. Of course, we have to lump together many disparate things in order to measure them, but the fact remains that according to this type of analysis, we could redirect every dollar currently spent on education to providing children with cigarettes, and the economy would be just as “healthy” in terms of GDP.

The point is not to argue against using the standard tools of macroeconomic analysis. Obviously it would be impossible to quantify the consequences of every individual transaction in an economy, and we must resort to abstract techniques if we want to be able to measure anything at all, but we must also avoid falling into the trap of mistaking man-made concepts like “GDP” and “money supply” for the actual economy.

So, when we talk about the “money supply”, what we are really talking about is an infinitely varied collection of instruments which have potential purchasing power. A dollar hidden under the mattress of a miser does not impact the economy in the same way as a dollar in the hands of a drunk at a blackjack table, but from the point of view of a monolithic concept like “money supply”, the two are indistinguishable. And, while we are all familiar with the big-picture monetary hazards called “inflation” and “deflation”, in actuality what is harmful is monetary instability in general. In fact, the very worst monetary scenario is “stagflation” in which aspects of inflation and deflation occur simultaneously. [For a more detailed discussion of money and the consequences of monetary instability, see my article entitled “American Economy: The Veil of Money”.]

So, while it is conceivable that the government could exactly offset the amount of money that has been wiped out by the credit crunch and thereby leave the “money supply” unchanged, this doesn’t mean that the result wouldn’t still be catastrophic. For example, the fact that the government is creating money by buying bad debts from banks is of little consolation to the family that is losing its home.

Another way of thinking about the economy is by way of metaphor. I like to think of the role of money in an economy as analogous to that of blood in a physical organism. Blood flows in different ways throughout all parts of an organism, and the overall health of the organism is dependent not only on the quantity of blood but also on it flowing properly. Maladies occur whenever the flow is too fast or too slow or impeded or misdirected. This metaphor is useful for addressing your question about why the government can’t just print an equivalent amount of money to the amount that has been destroyed in order to achieve a neutral effect on the economy. It would be as if we took a trauma patient who has lost a lot of blood and gave him a massive transfusion without knowing his blood type (although, whereas a random blood transfusion might end up working just based on blind luck, in the case of the economy, since there is an infinite number of “blood types”, a random transfusion cannot possibly work).

Another metaphor that I like to use when thinking about the role of money in an economy is to visualize a fertile river valley in the middle of a desert. The volume of water in the river determines how far in either direction crops will grow. So, for example, while in a drought year crops might only grow right next to the river, in a year with abundant rainfall the margin of cultivation will lie at a greater distance from the river. Now, let’s imagine that the flow of water is suddenly increased by artificial means. This will allow crops to be grown over a larger area of land than usual for as long as the artificially large flow is continued, but as soon as the unsustainable flow is interrupted, all of the crops that ordinarily would never have sprung up in the first place will wither and die.

I would liken the monetary policies of Alan Greenspan to the artificially high river. Rather than allow the boom & bust of the dot.com bubble to run its course, Greenspan turned the spigots wide open and let the river flow at an abnormally high rate that averted short-term pain but assured much greater destruction later on. All you have to do to see this with your own eyes is to take an airplane flight into Las Vegas (or Phoenix, or Miami, or Los Angeles…) and look at the massive number of housing developments in various stages of completion around the margins of the city. These developments are the equivalent of the crops that under normal circumstances never would have sprung up in the first place. As a result of artificially abundant money all of this excess housing stock has come into existence and must now be reckoned with before we can get the economy back on a sound footing. And simply printing money will not remedy the fact that the economic organism developed along unsustainable lines.

All of that being said, I am not arguing against the use of fiscal and monetary policy to deal with the current crisis. I am just not optimistic about our chances of success. I believe we will be unable to avert a crisis for two reasons.

First, to use yet another metaphor, imagine that the job of the financial authorities is to steer a ship through a winding channel. One side of the channel represents unemployment and economic stagnation, while the other side represents inflation and “irrational exuberance” (to borrow a Greenspan-ism). Under ordinary circumstances it is a difficult but manageable task to keep the ship safely within the channel and not to err too badly in either direction. However, the steering mechanism of the ship is highly imprecise and cumbersome. Much like steering an actual ship, you must always be thinking ahead and compensating before your errors become evident. If you fail to stay ahead of the curve, you have to resort to increasingly risky maneuvers in order to avoid harmful divergences, and each of these risky measures makes the next maneuver that much more difficult to execute safely until a point is reached at which there is no way to avoid a painful crack-up.

I would argue that this is the position that Bernanke and Paulson find themselves in right now. They are steering a ship that is careening wildly in an ever narrower channel. The truth is that most of the blame for the current situation lies not with Bernanke or Paulson but with their predecessors. Bernanke and Paulson could be the most intelligent, upright people in the world and still fail to avoid a collapse. Personally I don’t have a strong opinion one way or the other as to the abilities or integrity of either one, although I think it is worrisome that Paulson is one of the people who profited most from the abuses which caused the crisis in the first place. Putting Paulson in charge of the bailout is like a bank hiring the best safe-cracker to run its security department. He might in fact be the best guy for the job, but you have to question his motives, and with the kind of absolute, non-reviewable power the current plan seeks to give him, I wouldn’t take it for granted that he’ll do what is in the best interests of the average American.

Add to all of this the fact that we are in the middle of a presidential election (which means that most parties in Washington are just as concerned with their own political futures as they are with the state of the economy), and I just don’t see much cause to be hopeful that they will be able to thread the needle and come up with just the right set of solutions to avoid a painful and protracted crisis.

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