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Yet More DeLong Smackdown Watch: Yves Smith Raises Objection (3) to Dealing with the Financial Crisis

Larry Summers's believes (and I agree) that we can likely resolve the financial crisis by (a) using regulatory authority to induce banks and not-banks to recapitalize (thus raising their demand for risky assets) and (b) having the government fund its own or GSE's purchase of mortgages or having the government guarantee mortgages (thus reducing the supply to the private market of risky assets):


and so returning us to a good near-full-employment financial-markiet equilibrium.

Yves Smith disagrees, and in an attempted refutation raises what I call Objection (3): "It can't work, it won't work--at least not in the long run":

naked capitalism: Lessons from Japan Versus Wishful US Prescriptions (Summers/De Long Edition): Let's say that, in the end, the banks will have to get a public injection of funds. What might be some implications? First is that all these measures to shore up markets are a very indirect, inefficient, and therefore costly was to try to finesse the real problem, that a lot of institutions are or shortly will be insolvent. That says we should quit propping up the mortgage market... deal with the damage to families frontally rather than by trying to prop up home prices... the government has no reason to be shy about nationalizing institutions, and that means wiping out the equity holders before any funds are injected. Yet people like Summers seem remarkably loath to even voice that idea, as if it were somehow anticapitalist. Huh? What is anti-capitalist is privatizing gains and socializing losses....

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....

Note that [Summers] acknowledges that the government cannot keep asset prices from declining to their fundamental value but does not consider the implications. Even more bizarrely, he dances around the role of Freddie and Fannie, on the one hand arguing that they should be lenders of the "first, last, and every resort" (um, that means they are serving a public purpose) yet will not address the need to nationalize them. What gives? Similarly, he makes a motherhood statement that if banks get help from the government they should anticipate that that costs arecattached. But this is a charged area where details are far more helpful than platitudes...

Yves Smith is standing on the shoulders--well, not so much standing on the shoulders as walking in the footprints--or giants, specifically Karl Marx and Friedrich Engels, who wrote in 1850:

Reviews from Neue Rheinische Zeitung Revue: The years 1843-5 were years of industrial and commercial prosperity.... As is always the case, prosperity very rapidly encouraged speculation... [which] occurs... when overproduction is already in full swing... provides overproduction with temporary market outlets... precipitating the outbreak of the crisis and increasing its force.... When the Bank of England keeps its interest rates down in times of prosperity... capitalists with investments in loan capital thus see their income reduced by a third... under pressure to look for more profitable capital investments. Overproduction gives rise to numerous new projects, and the success of a few of them is sufficient to attract a whole mass of capital in the same direction, until gradually the bubble becomes general...

And, they say, the economy's problems cannot be cured by mere government financial manipulation:

The crisis itself first breaks out in the area of speculation; only later does it hit production. What appears to the superficial observer to be the cause of the crisis is not overproduction but excess speculation, but this is itself only a symptom of overproduction. The subsequent disruption of production does not appear as a consequence of its own previous exuberance but merely as a setback caused by the collapse of speculation...

That's Smith's argument: that Larry Summers and I neglect the implications of the fact that "the government cannot keep asset prices from declining to their fundamental value." How sound is it?

The fundamental value of any risky asset--housing, say--depends on (a) per-period value or profit, (b) the time profile of safe interest rates, (c) the quantity of risky assets that the private financial sector must bear, (d) the amount of risk associated with each tranche of risky assets, and (e) the risk-bearing capacity of the private market. All of things are things that can be high or low--and that the government can affect:

  • A competent government that keeps the economy near full employment boosts future profits and values; an incompetent government that fails to stem an economic collapse into depression diminishes them.
  • Similarly, a competent government that keeps asset prices from being pushed into fire-sale territory by irrational pessimistic panic diminishes the amount of risk associated with each tranche of risky assets.
  • The Federal Reserve controls the time profile of safe interest rates. No argument.
  • The government can buy up or guarantee risky assets, thus diminishing the quantity that the private market must hold--unless you adopt some hyper-Barrovian pose and are willing to maintain that Bernanke-Paulson puts are not net wealth.
  • The risk-bearing capacity of the private market can be extended via financial regulation that diminishes the chance that a relatively uninformed investor is being victimized by someone with inside information, and widens the pool of investors willing to bear risk.

What, then, is this "fundamental value" to which asset prices must decline if government policy can have effects--profound effects on nearly each of the factors on which fundamental value depends?

The Marx-Engels-Hayek-Smith line of argument does attempt a parry. It says that the root problem is overproduction--that we have too many houses. Attempts to change fundamentals will mean that those who build more houses will continue to earn more profits, and so we will have more and more and more houses, and we will have an even greater overproduction crisis some time in the future. So we must make sure that housing prices are so low that nobody builds another house for a long time to come, and that is the only way to minimize the misery coming out of the collapse of the housing bubble.

I have never been able to make this "overproduction" argument maske sense. If the government provides a subsidy--like a mortgage insurance subsidy--then we will indeed have more of whatever the government subsidizes, but there is no reason to think that this is in any way a big problem or an unsustainable situation. It may well be a waste of the government's money to provide the subsidy: taxpayers might rather endure a housing crash and a depression than be forking out extra taxes to pay mortgage guarantees. That's an empirical and a cost-benefit issue.

Smith's problem, to my mind, is that he appeals to slogans:

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....

without ever specifying what the costs and benefits of alternative policy paths are. John Maynard Keynes would say that a policy aimed at maintaining full employment via monetary policies that support asset prices and fiscal policies that directly stimulate demand can work, and do work, and that opposition to them is ultimately based not o pragmatic practicalities but on the memory of too many Anglican preachers denouncing the Mammon of Unrighteousness:

While some part of the investment which was going on in the world at large was doubtless ill judged and unfruitful, there can, I think, be no doubt that the world was enormously enriched by the constructions of the quinquennium from 1925 to 1929; its wealth increased in these five years by as much as in any other ten or twenty years of its history....

Doubtless, as was inevitable in a period of such rapid changes, the rate of growth of some individual commodities [over 1924-1929] could not always be in just the appropriate relation to that of others. But... [a] few more quinquennia of equal activity might, indeed, have brought us near to the economic Eldorado where all our reasonable economic needs would be satisfied.... It seems an extraordinary imbecility that this wonderful outburst of productive energy [over 1924-1929] should be the prelude to impoverishment and depression. Some austere and puritanical souls regard it both as an inevitable and a desirable nemesis on so much overexpansion, as they call it; a nemesis on man's speculative spirit. It would, they feel, be a victory for the mammon of unrighteousness if so much prosperity was not subsequently balanced by universal bankruptcy. We need, they say, what they politely call a 'prolonged liquidation' to put us right. The liquidation, they tell us, is not yet complete. But in time it will be. And when sufficient time has elapsed for the completion of the liquidation, all will be well with us again.

I do not take this view. I find the explanation of [depressions, i.e.] the current business losses, of the reduction in output, and of the unemployment which necessarily ensues on this not in the high level of investment which was proceeding up to the spring of 1929, but in the subsequent cessation of this investment. I see no hope of a recovery except in a revival of the high level of investment. And I do not understand how universal bankruptcy can do any good or bring us nearer to prosperity...

I'm with Keynes.