Grasping Reality on TypePad, by Brad DeLong

Yves Smith:

naked capitalism: Lessons from Japan Versus Wishful US Prescriptions (Summers/De Long Edition): Finally, there is a longish post by Brad De Long on Summer's article, in which he uses as point of departure a simple construct first posted by Paul Krugman (admittedly, De Long pushed around this model in an earlier post at some length). Krugman posited that there might be an S-shaped demand curve (supply is vertical, since at any point in time there is a fixed amount of securities). He further reasoned that there was a high-priced equilibrium, and a low-priced one that could be induced by panic, and the Fed was trying to get back to the high equilibrium (for reasons of space, I did not replicate his so-called cartoons, but you can see them at his post). But he concluded:

But at this point a series of rate cuts and other stuff just hasn't done the trick -- which suggests that maybe there isn't a high-price equilibrium out there at all.....And in that case, the Fed can't rescue the financial markets. All it -- and the feds in general -- can do is to try to limit the effects of financial crisis on the rest of the economy.

Yet De Long blithely ignores the conclusion that Krugman reached, and by implication, so does Summers.

What about "bubble" don't you understand? That high priced equilibrium was not stable, it was created by unsustainable leverage. Per Herbert Stein, "That which is unsustainable will not be sustained." It is neither good economics nor good policy to try to keep an asset bubble aloft.

First, Paul's claim that "the Fed can't rescue the financial markets" if the good equilibrium in the Backwards-S model has disappeared like so:

is not complete. The Fed can't rescue the financial markets through Bagehot rule policies that provide a firehose of liquidity at a penalty rate. Such Bagehot-rule policies work only with a Stage I financial crisis, when the Backwards-S diagram looks like this:

Second, I do not ignore the claim that, as Yves Smith puts it: "What about 'bubble' don't you understand? That high priced equilibrium was not stable, it was created by unsustainable leverage. Per Herbert Stein, 'That which is unsustainable will not be sustained.' It is neither good economics nor good policy to try to keep an asset bubble aloft..."

I explicitly write:

Objection (3) is intellectually more interesting and substantive. But that will have to wait for the next lecture.

Yves Smith is making a version of Objective (3). And I do have an answer to it. But, to quote Gandalf the White, "I have no time!" I do hope to make some more time soon, however.