How Depressions Work

http://www.aaronsw.com/weblog/depressions

by ph0rque • 17 years ago

54 95 17 years ago

Retric4• 17 years ago

That's one facet another is how deflation and loans mix. In effect deflation increases interest rates just as inflation decreases them. If you owe 1$ @ 5% over a year with 50% deflation you now owe 2.1 times the value of what you bought. Once deflation starts people start trying to pay back their debt because their effective interest rate increased. Which decreases the money supply and causes even more deflation. This cycle can quickly get extremely nasty with most people defaulting.

The free market dampener is people refinancing at slightly lower rates, but this this hits a wall. Negative interest rates never happens, because why lend money when you can just keep it. And even mild deflation is hard to deal with because loans have risk so you can't lower loans below the rate of risk.

kingkongrevenge5• 17 years ago

This is just a muddled explanation of monetarism, which is pretty well clearly nonsense at this point. No macroeconomic developments of the last 100 years confirm it.

> We’re not being punished for our exuberance

We're being "punished" for massive malinvestment. Wealth was poured into assets and ventures that could never achieve positive returns. A recession/depression is the process of liquidating malinvestments and redeploying wealth and labor to economically profitable ventures.

The malinvestment happens partly from mass psychology and mostly because of artificially manipulated interest rates. The natural market interest rate reflects the amount of wealth available for investment (capital). When people have saved a lot and there's a lot of wealth stored up, interest rates are low. When interest rates are artificially held low, investors and business people get the mistaken impression there's much more stored wealth in the society than there actually is. Then eventually many business plans come to tears at roughly the same time, as it becomes apparent there isn't the wealth to drive demand for the ventures. This is a recession.

Retric4• 17 years ago

Depressions are what happens when Recessions start feeding off of their own fall. Looking back at the great depression the amount of knowledge did not change, the workforce did not change, the amount of natural resources did not change much, but things kept getting worse. Over the long term Recessions are useful but Depressions can cause a lot more harm than good.

PS: We are not in a depression, but a major goal should be to avoid a depression while we let this recession fix many of the problems your talking about.

kingkongrevenge5• 17 years ago

The change in the depression was massive government intervention. Hoover reacted quickly with unprecedented price support programs and stimulus to preserve the status quo. FDR upped the ante, and kept doing it for many years. There was a depression because the mistakes of the 20s were not swiftly liquidated.

The policy prescription for the current crisis is to beef up food stamps and heating assistance programs so people don't starve or freeze, and then let all nonviable businesses fail as quickly as possible so they can be reconstituted as profitable companies.

jacoblyles• 17 years ago

That's the Austrian view, anyway.

fizx• 17 years ago

Check out this podcast. http://www.econtalk.org/archives/2009/01/roberts_and_han.htm... about different viewpoints in economics, and economists talking about how much they know and don't know.

mhartl6• 17 years ago

I find it strange that there still exist named schools of thought in economics; perhaps it's a sign of the field's intellectual immaturity. After all, which schools of thought are there in chemistry or physics? A few centuries ago you could have answered that question, but today it doesn't even make sense. I wonder if economics will ever reach the same level of development.

For what it's worth, the only economists who consistently avoid setting off my bullshit meter are the Austrians. And yet, their views border on lunatic fringe according to mainstream economists. In a world where those same economists set policy, that is an alarming combination.

jorgeortiz854• 17 years ago

A recession/depression is the process of liquidating malinvestments and redeploying wealth and labor to economically profitable ventures.

If what you say were true, then we wouldn't be suffering from unemployment. We'd suffer from massive writedowns in our wealth (as we realize our malinvestments) but labor would be redeployed to new ventures. Effectively, we'd be working our assess off harder than before, but receiving a lower quality of life in return.

In reality, however, the economy is not at full employment. If we malinvested before (effectively did useless work), that should be a sunk cost. We wouldn't receive the future benefits we expected from that work, but that wouldn't preclude us from continuing to work. Malinvestment is not a reason for unemployment.

No, we're in a liquidity trap. Option A is monetary policy. That has been tried and exhausted. Option B is fiscal policy. Bring out the helicopters!

kingkongrevenge5• 17 years ago

> If what you say were true, then we wouldn't be suffering from unemployment.

Uh, why not? I don't get it. Of course business liquidations and a decline in capital investments produces unemployment.

richcollins3• 17 years ago

> but labor would be redeployed to new ventures

Labor won't be deployed to new ventures when all of the companies that were involved in the malinvestment aren't allowed to fail.

gojomo3• 17 years ago

we wouldn't be suffering from unemployment... labor would be redeployed to new ventures

Yes, but redeployment takes time -- especially when everyone looks around and sees all their assumptions about what profits different activities will return are wrong, and need to be recalibrated. That research -- which happens tentatively, experimentally at first -- means some capital/labor sits on the sidelines while the necessary information is collected or created.

Redeploying labor immediately at the first things you can think of might keep people busy but can worsen the wealth destruction, if those activities wind up being of net zero or negative benefit. (By tying up workers on make-work, they could also slow the rediscovery and restaffing of valuable projects.)

corentin• 17 years ago

Malinvestment also applies to labor. Workers need to retrain before they can start new productive jobs, and they need capital as well (not easy, since the US are borrowing instead of saving).

mixmax2• 17 years ago

He needs to learn about inflation too ;-)

richcollins3• 17 years ago

I agree that it is nonsense.

If hoarding leads to an irrationally priced money, rational people will quickly realize this and exchange their money for other alternatives that have become favorably priced.

Once this tipping point is reached, others will realize that they were overvaluing their money and the pendulum will swing back.

bokonist5• 17 years ago

Some people are losing their jobs because they were in sectors that had too much malinvestment ( housing).

But many other are losing their jobs simply because of friction caused by the increase in demand for money. All contracts ( wage contracts and debt contracts) were written assuming an easier availability of money. When a deflation occurs, many businesses go bust not because they were "malinvestment" but simply because their contracts were denominated in 2007 dollars, not 2009 dollars. The correct response is to print money to prevent the deflation, thus removing the need for every business in the country to into bankruptcy court to get out of their debts.

Before the Great Depression, many people wanted cars and they could afford cars. After the great depression, the production of cars were even greater. Why did the factories need to stay idle during the great depression? Idle automobile factories were not a result of liquidating malinvestment, they were a result of collateral damage from deflation.

rsheridan6• 17 years ago

Deja vu: http://www.slate.com/id/1937/

johnrob3• 17 years ago

Inflation is one way to solve a debt crisis. What ends up sacrificed is the reputation of the currency (dollar in this case). Our spending power as a nation will decline when the rest of the world demands more dollars for their goods.

I have wondered lately if this is why we are keeping our car companies alive: Massive inflation could make them cheaper than foreign cars.

cchooper5• 17 years ago

He's proposing an expansion of the money supply, not inflation. It will only lead to inflation if the money is not withdrawn quickly enough as the economy recovers.

johnrob3• 17 years ago

It's all relative. Expanding the money supply has an inflationary effect, even if the absolute effect is simply to slow deflation (which is still relative inflation).

dominik5• 17 years ago

Wait a second, isn't inflation = expansion of the money supply, i.e. monetary inflation? Price inflation comes later as a direct consequence of monetary inflation, as effects propagate through the economy.

Also, how could money "be withdrawn quickly enough"? Who would withdraw it and how?

dominik5• 17 years ago

"Keynes suggested stuffing bills into bottles and burying them down mineshafts."

Can someone explain how such an action would help the economy?

jorgeortiz854• 17 years ago

If people are jealousy guarding their cash for fear of losing wealth on other investments (seriously, what else would you invest in, in this environment?), then printing cash and throwing it around is SO irresponsible that no one can credibly believe their bills will maintain value. They'll spend their cash on goods and services rather than see it's value disappear.

there• 17 years ago

to get at the money, one would have to employ people and buy equipment.

mechanical_fish2• 17 years ago

Yep, that's it.

It would be nice if these people did something useful, but Keynes' point was that this is an optional feature which should not be allowed to detract from the main goal.

arebop• 17 years ago

Then, the idea was to let miners dig them back up. The burying and mining activities themselves are silly and useless, but then the multiplier effect kicks in. Keynes says the important thing is to get money circulating so that resources can (eventually) be put to practical use, whereas if everyone saves and does not reinvest then potentially productive resources are left fallow.

http://www.economictheories.org/2008/11/keynes-theory-of-sav... gives a little more context.

tptacek4• 17 years ago

Isn't this just a point-for-point paraphrase of a Paul Krugman article, about the same co-op? He didn't even cite Krugman, or the journal article Krugman cited for the same story.

aaronsw• 17 years ago

Oops, I meant to add footnotes. Sweeney and Sweeney is here:

http://cda.morris.umn.edu/~kildegac/Courses/M&B/Sweeney%...

It's an awesome paper.

tptacek4• 17 years ago

It is an awesome paper, but it doesn't appear to be your primary source --- which you haven't yet cited (it's "Babysitting the Economy", Krugman in Slate from '98, about the Asian crisis).

For example, unlike Krugman, the original paper doesn't state that the co-op is mostly lawmakers and lawyers (only that lawyers drafted the bylaws); unlike your post and Krugman's article, the paper also doesn't talk about legislation.

More importantly, the paper's thesis isn't Krugman's thesis, or yours. The paper seems to be making the point that the implicit economies that develop from social interactions are often destined to flail because people don't recognize them as economies, and insist on applying moral reasoning to technical problems.

But your thesis --- and Krugman's --- is different. Obviously, we recognize The Economy as an economy. So what Krugman is saying is that this story illustrates something about how to resolve a depression.

Which it very well might. It's not like I'm going to question Krugman on it.

(You did cite Krugman's anthology book, which I haven't read but might contain this article).

johnrob3• 17 years ago

How will this help us pay the 45 trillion dollars of combined public and private debt? Keep in mind our GDP is 13 trillion.

sethg2• 17 years ago

The Keynesian prescription, AIUI, actually has two sides: the government should run a deficit (when necessary) during a recession and run a surplus during a recovery.

It's a damn shame that the Bush Administration didn't follow the second half of this advice for the past eight years, but that's no reason to ignore the first half now.

mixmax2• 17 years ago

If you cut away all the economist talk and get down to the core of the problem it's very very simple: For the last 8 years America has been spending more than it has made. Production is not up to world standards, just look at the auto industry.

Bailing out companies and fiscal stimulus of one sort or another won't save you from the basic and indeniable problem: You're broke.

There's only one way out of that: Spend less and work more.

cool-RR• 17 years ago

In the "scrip" economy, couldn't they just let the value of the scrip change organically? If scrips are getting too precious, you can tell your babysitter that he'll be getting one scrip per two hours instead of one hour. If scrips are indeed that rare, he'll accept it, and the scrip-time ratio will naturally reflect the scarcity of scrips. Since this thing does happen with Dollars, I reckon his analogy is bad, and adding more Dollars won't solve the problem.

mhartl6• 17 years ago

You've got it. I made the same point a few weeks ago: http://news.ycombinator.com/item?id=421617. It doesn't seem like rocket science, but maybe it is; the vast majority of economists, including Nobelists like Krugman, just don't seem to get it.

bokonist5• 17 years ago

I made almost the exact same comment you made: http://www.reddit.com/r/Economics/comments/6oba0/its_ten_yea...

richcollins3• 17 years ago

Yep, looks like it was a lack of money in circulation that caused the problem:

http://research.stlouisfed.org/fred2/fredgraph?chart_type=li...

baguasquirrel3• 17 years ago

The velocity of money has dropped. I don't have the charts on hand, but you're citing that chart and making the wrong conclusions.

stevedekorte• 17 years ago

A long response to Krugman's scrip example can be found here:

http://www.amconmag.com/article/2009/jan/12/00031/

petercooper• 17 years ago

Aha.. I've seen the "interest rates can't go below zero" claim again. Is this really so? I've read it a lot, but surely a negative interest rate is possible by being paid interest to borrow money?

A negative interest rate, therefore, would be a bit like a formalized "helicopter drop". If the interest rate of a loan were tied to the nominal interest rate in some way, you wouldn't have millions borrowing as much as possible because the rates could well shift back in the other direction before long.

vitaminj2• 17 years ago

Some economists have proposed imposing a tax on cash holdings, which would theoretically push nominal interest rates negative... this would really give people an incentive to hold assets instead of cash.

vitaminj2• 17 years ago

http://blogs.ft.com/wolfforum/2008/11/the-case-for-negative-...

bokonist5• 17 years ago

This isn’t rocket science. Keynes suggested stuffing bills into bottles and burying them down mineshafts; Milton Friedman once proposed tossing cash out of helicopters. But as long as the government is spending money, we might as well spend it on something useful. And thus, fiscal stimulus.

I agree with printing money to halt the deflation. But this should not be done through government projects. If the money is spent via government projects, then you still get massive frictional unemployment as businesses shut down and and everyone has to find new jobs working for the government. Second, government spending has a ratchet effect. Government programs never die. Finally, I believe individuals know how to spend their money the best. Should money be spent on a high speed train from Boston to Washington, or should it be spent on healthcare? Just print money and give it to individuals and let each person decide.

swombat• 17 years ago

As I recall, an article I read recently outlined a few key principles for such a monetary deployment (which Lawrence Summers apparently supported until he became part of the administration):

1) Must be able to start very soon

2) Must have a clear horizon (i.e. a project with a final deadline, so that it doesn't keep costing money forever)

3) Must be useful

One example it gave of the best way to spend that money would be actually to repair existing roads. That's usually very easy to do right away, provides immediate short term benefits, and reduces your long term costs (unlike building roads, which increases them, as you then have to maintain all these new roads).

bokonist5• 17 years ago

The point of monetary deployment should be balance sheet repair. Only when people's balance sheet's are repaired can normal spending resume and the layoffs stop. The point of an intervention now should not be to get the unemployment rate back down to 4%, but to prevent it from going to 15%. Therefore, the thing to do is to repair balance sheets by printing money. If you only give money to people repairing roads then consumer spending still drops off a cliff, and millions of people still lose their jobs.

hardik3• 17 years ago

"The moralists insist it’s irresponsible for us to just print more money."

Actually economists, not moralists, are against this; because excessive pumping of money in they system in this way will cause hyper-inflation. Classical (and rather extreme) example of why printing money should be kept under check: Zimbabwe.

sethg2• 17 years ago

Everyone agrees that excessive pumping of money into the system will cause inflation. The problem is figuring how how much is, in fact, excessive. And in a recession, you can't just say "let's err on the side of conservatism and not pump anything in" because there's the risk of deflation on the other side.

"We stand today at a crossroads: One path leads to despair and utter hopelessness. The other leads to total extinction. Let us hope we have the wisdom to make the right choice." —Woody Allen

hardik3• 17 years ago

Well, the fact that interest rates are nearing zero does indicate how must is not enough.

tphyahoo• 17 years ago

An alternative explanation:

http://www.whereisthemoney.org

You shouldn't just print money if it supports theft via nontransparent government accounting, impoverishes the many, and enriches the few.

Then you are just Zimbabwe 2.0.

Fix the accounting systems first, please.

How Depressions Work

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