May 14, 2011

The Macroeconomics Credibility Gap

I posted this response to a Paul Krugman column bemoaning how nobody takes monetarists seriously anymore.

The reason the various schools of macro have failed to predict recession cycles for decades, is they do not recognize that the root cause is the buildup of undercollateralized credit, i.e. leverage. This is the essential point that heretics like Hayek and Misnky make, yet it continues to go unaddressed. Instead, a psychological phenomenon called an aggregate demand gap is blamed, when in fact the demand gap represents a (temporary) return to less leveraged financial practices and attitudes. The market failure is set up by the failure of government to properly regulate the use of leverage, and then compounded with moral hazard when government "intervenes" in the aftermath to reward the leverage abusers. 
If the leverage cheaters--the Fannie Maes who issue credit on less than 2% reserves--are not cleaned out periodically, capital is increasingly tied up in zombie non-performing assets (e.g. CDOs and houses) that can pretend they are performing as long as debts can be continually rolled over and increased to cover cash flow losses--requiring infinite dovish monetary policy. This eventually hits the zero bound on interest rates--the "liquidity trap"--unless the market or the Fed ends the party before zero is hit. This is the "liquidity trap" that gets a lot of attention in this space. The proper policy response is not to double down on government debt, but a regulatory and law enforcement response to clamp down on the undercollateralized credit defrauding the nation's money supply.
Until macroeconomists understand that the demand gap represents not a market failure, but the gap between sustainable and unsustainable credit-driven consumption, they will continue to be (rightly) derided outside rarefied academic and Washington DC airs. Monetary vs. fiscal policy vs. free markets is beside the point.
If I had to boil down the structural economic problems in capitalist society today, it comes down to one word: leverage.  Certain persons and organizations are granted leverage privilege; all other must pay cash.  This is what keeps the rich growing richer--they can buy stuff without spending money.

Your brokerage account is settled nightly (and sometimes intra-day if you exceed margin limits).  Goldman Sachs  gets weeks or months to settle transactions.  Banks get to hold assets on their books for years pretending they have value, even if the debtor is no longer paying at all.  The US government plays many games with leverage in its books such as with the Social Security "trust fund".  Finally, there's the whole institutionalized leverage system that banks follow known as fractional reserve lending.  The little guy without access to cheap credit can't get anywhere.

It is worth noting that gold is not the solution to undercollateralized credit.  Banks issued banknotes in the late 19th century that became worthless when no one would accept them.  Credit is created every time a supplier grants 30 day payment terms to a customer.  Instead of the gold standard, we should be better defining the boundaries between credit and fraud, and enforcing sanctions against fraud.

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