Grasping Reality on TypePad, by Brad DeLong

Financial disasters… It seems to me that there are kinds of financial disasters… The first is a disaster for the real economy--interesting how we use that phrase to distinguish the real economy from the financial economy--that has a financial disaster, collapsing asset values and wealth, as a consequence. Here the problem is not in finance, and cannot be fixed by anything in finance. The second is a disaster for some kind of money or wealth--dollars become worthless relative to pounds, or collapsing risk tolerance means that junk bonds become nearly worthless relative to treasury bonds. This is, overwhelmingly, simply a redistribution: the same stuff is being made by the same people in the real economy, but some of the people whose financial wealth led them to assume that they had control over that stuff were wrong, and conversely those whose financial wealth was in the form of money that retains its value find that they have received a large windfall. This is a big problem if your wealth is in the form that is on the losing side of, say, the German hyperinflation of 1923. But the solution to this kind of problem is simple: diversification. Diversify your wealth across as many possible asset classes as you can, and you will be nearly invulnerable. The third kind of financial disaster is a financial disaster that as a consequence affects the deal economy as well--one that does not just redistribute real wealth, but destroys it, with the financial collapse and redistribution somehow ripping large holes in the social division of labor and in the web of production, work, and enterprise. This is, I presume, what you are looking for... On an international level, what we should be doing is topping off the funding of the IMF, because it is the organization that exists to backstop various forms of money and to quickly resolve contain whatever panic happens from the sudden realization that it appears that some particular form of money is about to become worthless. On a national level, we need to be requiring that banks have much higher equity and much lower debt in their capital structures--for the principal source of panic is always a run on the bank, which happens when people rightly fear that the bank is undercapitalized and the last people to try to pull their money will get nothing. On an individual level--well, the things you stockpile if you are scared of a total collapse of the social division of labor are bottled water, sewing needles, and ammunition. And joining the Church of Jesus Christ of Latter Day Saints is not a bad idea either. A lust for gold seems to me at least be the product of an awful lot of fuzzy thinking: actual resources that you can use to produce useful commodities are no longer worth anything, and the obligations of the US government are no longer worth anything, and yet people are supposed to still be willing to respect your property right to your gold? If you want gold under such circumstances, much better to have secured control of MREs and simply charge people 5 pounds of gold for a meal…"

I believe Hayek was Schumpeter's comrade in this, claiming that at the bottom of Keynes's theory was "immorality" otherwise unspecified…

The usual line of attack, subterranean, goes through Keynes's homosexuality to his childlessness sent ends with a striking misconstrual of his "in the long run we are all dead." In proper context, this is not a call to ignore the long run but instead a call not to ignore the short run: "It would follow... that an arbitrary doubling of [the money stock], since this in itself is assumed not to affect [the velocity of money or the real volume of transactions] ... must have the effect of raising [the price level] to double what it would have been otherwise. The Quantity Theory is often stated in this, or a similar, form. Now 'in the long run' this is probably true. If, after the American Civil War, the American dollar had been stabilized... ten per cent below its present value ... [the money stock] and [the price level] would now be just ten per cent greater than they actually are.... But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again." The task is "too easy" because solving any model for the long-run is easy and avoids all the interesting issues. The task is "too useless" because it gives no guide to the public official as to how to restore the peaceful, progressive Edwardian world. The interesting thing, from my perspective, is that it requires the glue of homosexuality and the decadence of Bloomsbury to hold this line of attack together. The idea that Keynes was concerned only with the short run finds no support in the text. The idea that his childlessness was a sign of ruthless concern only for the transitory pleasures of the moment is hard to sustain given the life he led. But with homosexuality as a glue, the whole thing could stick together.

As I see it, there are four groups here: 1. There are financial creditors, who benefit when interest rates are high and inflation rater are low because then they earn high real returns on the money they invest, and who suffer when interest rates are low and inflation rates are high; 2. There are financial debtors, who benefit when interest rates are low and inflation rates are high because then they are able to borrow cheaply in real terms, and who suffer when interest rates are high and inflation rates are low; 3. There are owners--people who own and control real stuff that is valuable and productive, equity holders, but also workers with valuable complementary skills and bargaining power as well--who also benefit when interest rates are low and inflation rates are high because the value of what they own goes up, and who suffer when interest rates are high and inflation rates are low because the value of what they own goes down; and 4. There are middlemen--people who invest long and risky and who borrow short and try to persuade those they borrow from that their money is still liquid and safe. Monetary policy must redistribute among these four groups in order to work. From a public policy standpoint, the object is to provide the right incentives to the owners--to make the prices of what they own right given what is going on in the rest of the economy so that the owners make what they should and build out capacity where they should and so get us full employment without accelerating inflation. The aim is macroeconomic balance--a balance that we are now falling short of on both dimensions, with both lower inflation than is good for us and higher unemployment. But none of the four groups wants this balance, Owners want higher asset prices always. Creditors want higher interest rates and lower inflation always. Debtors want lower interest rates and higher inflation always. And middlemen want large spreads--which is why the current policy configuration terrifies them, because the fact that you don't pay negative interest rates puts a floor on their costs and the fact that people react very negatively to red numbers in spreadsheets means that their clients are likely to get very angry when the overall level of nominal interest rates is low, even if the middlemen are adding as much value (or more: when times are unusual you want smart professionals managing your money) as in normal times. To the extent that you worry about the impact of monetary policy on income and wealth distribution, it seems to me that all in all it is creditors and middlemen who are the richest, and thus that you should be leery of higher interest rates rather than fearful of lower ones.

Monetary policy inevitably makes some industries profitable and others not. Right now one of the industries that monetary policy is making unprofitable is the commercial banking industry. But that does not mean that this is a worse world than one in which interest rates were higher and other industries were unprofitable instead.