And so economic turmoil continues around the world. My own investments are no exception - my US stocks have averaged a 33% loss this month, though I am better off than some of my friends who have lost almost everything. Iceland is broke (though that's just bad news for incumbents; for everyone else, that means there's plenty of opportunity there), and Argentina is on its way.
Recently I have heard some more discussions of how the government should help the economy turn the corner. Most of these are one kind of bailout solution or another to improve liquidity and ease the credit crunch. Ideas include:
1) Bailing out the financial institutions' bad investments by buying up bad assets.
This obviously is bad for taxpayer, as there is no reason any asset which will not sell above market price while in the bank's hands will now sell in the government's hands. Maybe prices will go back up, but there is no guarantee, and they certainly will not go up to the prices at the top of the bubble, so a loss is expected regardless. The government tries to paint this as an investment, not an expense; that is true, but a bad investment (which is what this is for certain) is almost as bad as an outright expense. Finally, there is no guarantee that this will improve liquidity, as the banks see no reason to lend out any more money to help out homeowners in this environment even if it has the money.
2) Loaning financial institutions the money to cover temporary cash shortages.
Once again, there is no guarantee here to improve liquidity. Furthermore, given the trouble some of these institutions are in, there of course is some risk of default.
3) Taking an ownership position in financial insititutions, forcing them to loan out money.
This of course might work, but it isn't clear how good a job a government can do to run a bank. Also, the reason financial institutions are tight on credit is valid, and it is likely that many of the loans they would make, while sensible in a normal environment, may be bad in the current environment. Thus, the risk of default is higher, and thus to force financial institutions to do so regardless will inevitably cause such institutions to lose money and shrink in size.
4) Helping homeowners directly by making loans available to them at low interest rates.
Of course this is the most direct and easiest way to help the homeowner, but the policy will have unintended consequences. Homeowners, seeing a source of liquidity available, may rush over to refinance and take advantage of the lower interest rates. This eases the credit crunch and ameliorates economic woes by temporarily stimulating the economy, but results in the start of another bubble, as you'll once again have people who take loans out and live beyond their means, etc. Soon the cycle will start again only it will be even worse the next time.
So in fact, I don't believe there is a way the government can help The best thing is to do nothing and let the markets ride it out. The recession in fact is much needed, and the restructuring that happens then will be the best thing in the long run. Bad banks will fail and better ones will grow and take its place. Credit will tighten, but the best investments will still be worthwhile projects to finance. The invisible hand of the market really works, and government should stop meddling with it, wrecking havoc, and then blaming the free market economy for problems it has caused, giving it more justification to nationalize and further regulate the economy. Keynesian policies advocating government intervention may have their place and time, but right now clearly is not one of them. Mainstream economics have mostly followed Keynesian thought in the past few decades, and that has led us to the crisis we have today.
Showing posts with label Austrian Economics. Show all posts
Showing posts with label Austrian Economics. Show all posts
Thursday, October 30, 2008
Wednesday, October 1, 2008
Global Economy Meltdown
I spent the 40 of the last 72 hours reading about the current financial situation, and while quite time-consuming (and perhaps obsessive), I think it has helped me better be able to comprehend financial news, its implications, and so on. Economics is unlike math and hard sciences in that theories/theorems are not universally accepted - different schools of thoughts hold different philosophies, and the events of the world are interpreted in different ways, each through their own lens.
While I still do not feel I have a complete grasp of modern economic theory and thought yet to debate forcefully and dogmatically on the best course of action to take to help the ailing economy, my leanings have fallen increasingly towards the Austrian school of thought. And through this lens, it is becoming more and more clear that we seem to be headed for a meltdown of the global economy.
According to the Austrian school of economic thought, the current financial crisis, as with all boom-bust business cycles is caused by artificially low interest rates. Artificial low interest rates are due to the Central Bank injecting newly printed money into the system via lending. This results entrepreneurs making systematic errors in judgment and many of them invest in larger projects with better returns. Other businesses may also take decide to take advantage of low interest rates; they borrow to upgrade old capital infrastructure in order to keep up with other businesses and entrepreneurs.
However, this over-investment causes an artificial bubble that temporarily lifts prices and production. At the same time, artificially low interest rates results in everybody taking advantage and wanting slightly less money now instead of slightly more money in the future. Depositors withdraw from their bank accounts and decrease savings, banks in turn will need to ask their borrows for payment, worsening the interest rate and credit situation.
Eventually, the buildup will not last: artificially stimulated demand will fall, entrepreneurs will find that their investments are in error because order sizes are not high enough, and these bad investments will need to be liquidated. A crisis or credit crunch may occur, which is just the market's way of trying to reset its time preferences for money - i.e. interests rates will need to go up in order for any further lending to occur. The following recession or depression is simply the process where the economy tries to correct for these mistakes and wastes that occured during the boom. The longer the period of artificial growth, the more longer or more painful the period of correction will be. Further information can be found on Wikipedia (http://en.wikipedia.org/wiki/Austrian_Business_Cycle_Theory) as well as many other places on the web (another good read on a related topic can be found here).
The US Government sponsored bailout along with artificial low interest rates (both of which involve injecting more newly printed money into the economy) will only serve to exacerbate the situation in the long run while helping to temporarily prop up the economy in the short run. Normally, in any other country, such actions would result in currency depreciation, but the US is a special case. The US, being the world's leading economy, has the special distinction of being the world's reserve currency. In other words, the other countries of the world treat the US dollar to be as good as gold. It is the currency of choice they use in their own foreign reserves to back their treasuries. As a result, it is not subject to the same degree of inflation as other countries if they tried the same tactic to a similar degree.
Perhaps a simple (though hopefully not too oversimplified) illustration will help. Let's assume country is a player in some game that requires trade, and that the unit of exchange is gold. In other words, gold is money; it will be recognized everywhere and between all people. In this game, the US is the one player that owns an inexhuastible gold mine. Whatever goods he wants from other countries, say cars from Japan or electronics made in Taiwan, or furniture manufactured in China, he can simply go digging around and unearth an extra nugget or two of gold that was not in the game before, and was not earned from productive work or trades with other players. The other players, such as Japan, China, and Taiwan, don't mind handing over their finished goods to the US for now in exchange for this "gold", because it enables them to keep up productivity and become wealthier (after all, there isn't really another supply of gold anywhere else in the game, and gold is currency, which allows them to give financial aid to the improverished players such as South Africa, Gambia, Swaziland, and Guinea-Bissau).
Now in some ways, you can accuse the US of "cheating" in the game - he doesn't need to produce very much and yet continues to be very rich, and can afford to continue to buy up cheap products made overseas due to the strength of his credibility. However, in real life, this situation isn't one that could last forever. The US may weaken, and it's reputation and credit may fall in the eyes of other nations. In time, when there is a suitable alternative, some other paradigm for how the world works, there could be a swift and ugly move away from the US. Say after the some major catastrophe that affects the US, Japan first decides to slowly unload its reserve of US dollars. China, sensing the same, may follow suit. The ensuing sale of USD will calls the dollar to depreciate drastically, better reflecting it's true value now that the other players of the world have wised up and stopped trading its finished goods for worthless scrap paper. Other nations, who have pegged their currencies to the dollar, will find it no longer unreliable and float their currencies on the open market instead. Soon, everyone will wake up to the realization that the US can't afford what it buys, and the dollar is not the new gold. It's difficult to gauge when this might happen, perhaps in 50 years, 10 years, 5 years, or maybe even sooner, given the current financial crisis, but it may be well worth it to diversify away from USD and into other currencies or into commodities like gold at this point.
However, coming back to the present - right now, no one is dumping US dollars yet. The US is so intertwined with the global economy, and since its notes are the foundation of foreign reserves around the world, it's woes will dramatically affect the rest of the world. As a result, instead of the US suffering alone and having its currency crash, production will slow around the world now that the top consumer in the world has slowed. Other countries' entrepreneurs will also see that they have overinvested, and that demand will not be high enough to justify such production. These unsustainable investments will be liquidated as well, and the resulting turmoil may drag nations around the world into deep recessions or even depressions.
In fact, former presidential candidate Ron Paul seemed to have predicted all of this, and has been proclaiming the same message in the past 20 years. The problem with the Austrian economists isn't that they are not right - they just aren't able to tell you when. Then again, part of it has to do with the fact the US Government always seems to be solving near-term economic problems instead of long-term ones, thus delaying the inevitable. Back during the very beginning of the millenium, after the dot-com bubble, and incidents of 9-11, the US felt it could not afford to wait out the recession, and once again artificially stimulated the economy with low interest rates, resulting in rampant borrowing, overpriced housing, and our current economic woes. Further attempts of a similar kind may hide or minimize the problem temporarily, but only lead to an even longer and more painful collapse.
The US economy is sick, and yet the doctor, instead of prescribing rest, pumps more drugs into his patient's body to address the symptoms, then encourages him to continue on. One of these days, the patient may no longer respond to the drugs, his body may crash and he may be forced to rest. Or worse, he may perish.
While I still do not feel I have a complete grasp of modern economic theory and thought yet to debate forcefully and dogmatically on the best course of action to take to help the ailing economy, my leanings have fallen increasingly towards the Austrian school of thought. And through this lens, it is becoming more and more clear that we seem to be headed for a meltdown of the global economy.
According to the Austrian school of economic thought, the current financial crisis, as with all boom-bust business cycles is caused by artificially low interest rates. Artificial low interest rates are due to the Central Bank injecting newly printed money into the system via lending. This results entrepreneurs making systematic errors in judgment and many of them invest in larger projects with better returns. Other businesses may also take decide to take advantage of low interest rates; they borrow to upgrade old capital infrastructure in order to keep up with other businesses and entrepreneurs.
However, this over-investment causes an artificial bubble that temporarily lifts prices and production. At the same time, artificially low interest rates results in everybody taking advantage and wanting slightly less money now instead of slightly more money in the future. Depositors withdraw from their bank accounts and decrease savings, banks in turn will need to ask their borrows for payment, worsening the interest rate and credit situation.
Eventually, the buildup will not last: artificially stimulated demand will fall, entrepreneurs will find that their investments are in error because order sizes are not high enough, and these bad investments will need to be liquidated. A crisis or credit crunch may occur, which is just the market's way of trying to reset its time preferences for money - i.e. interests rates will need to go up in order for any further lending to occur. The following recession or depression is simply the process where the economy tries to correct for these mistakes and wastes that occured during the boom. The longer the period of artificial growth, the more longer or more painful the period of correction will be. Further information can be found on Wikipedia (http://en.wikipedia.org/wiki/Austrian_Business_Cycle_Theory) as well as many other places on the web (another good read on a related topic can be found here).
The US Government sponsored bailout along with artificial low interest rates (both of which involve injecting more newly printed money into the economy) will only serve to exacerbate the situation in the long run while helping to temporarily prop up the economy in the short run. Normally, in any other country, such actions would result in currency depreciation, but the US is a special case. The US, being the world's leading economy, has the special distinction of being the world's reserve currency. In other words, the other countries of the world treat the US dollar to be as good as gold. It is the currency of choice they use in their own foreign reserves to back their treasuries. As a result, it is not subject to the same degree of inflation as other countries if they tried the same tactic to a similar degree.
Perhaps a simple (though hopefully not too oversimplified) illustration will help. Let's assume country is a player in some game that requires trade, and that the unit of exchange is gold. In other words, gold is money; it will be recognized everywhere and between all people. In this game, the US is the one player that owns an inexhuastible gold mine. Whatever goods he wants from other countries, say cars from Japan or electronics made in Taiwan, or furniture manufactured in China, he can simply go digging around and unearth an extra nugget or two of gold that was not in the game before, and was not earned from productive work or trades with other players. The other players, such as Japan, China, and Taiwan, don't mind handing over their finished goods to the US for now in exchange for this "gold", because it enables them to keep up productivity and become wealthier (after all, there isn't really another supply of gold anywhere else in the game, and gold is currency, which allows them to give financial aid to the improverished players such as South Africa, Gambia, Swaziland, and Guinea-Bissau).
Now in some ways, you can accuse the US of "cheating" in the game - he doesn't need to produce very much and yet continues to be very rich, and can afford to continue to buy up cheap products made overseas due to the strength of his credibility. However, in real life, this situation isn't one that could last forever. The US may weaken, and it's reputation and credit may fall in the eyes of other nations. In time, when there is a suitable alternative, some other paradigm for how the world works, there could be a swift and ugly move away from the US. Say after the some major catastrophe that affects the US, Japan first decides to slowly unload its reserve of US dollars. China, sensing the same, may follow suit. The ensuing sale of USD will calls the dollar to depreciate drastically, better reflecting it's true value now that the other players of the world have wised up and stopped trading its finished goods for worthless scrap paper. Other nations, who have pegged their currencies to the dollar, will find it no longer unreliable and float their currencies on the open market instead. Soon, everyone will wake up to the realization that the US can't afford what it buys, and the dollar is not the new gold. It's difficult to gauge when this might happen, perhaps in 50 years, 10 years, 5 years, or maybe even sooner, given the current financial crisis, but it may be well worth it to diversify away from USD and into other currencies or into commodities like gold at this point.
However, coming back to the present - right now, no one is dumping US dollars yet. The US is so intertwined with the global economy, and since its notes are the foundation of foreign reserves around the world, it's woes will dramatically affect the rest of the world. As a result, instead of the US suffering alone and having its currency crash, production will slow around the world now that the top consumer in the world has slowed. Other countries' entrepreneurs will also see that they have overinvested, and that demand will not be high enough to justify such production. These unsustainable investments will be liquidated as well, and the resulting turmoil may drag nations around the world into deep recessions or even depressions.
In fact, former presidential candidate Ron Paul seemed to have predicted all of this, and has been proclaiming the same message in the past 20 years. The problem with the Austrian economists isn't that they are not right - they just aren't able to tell you when. Then again, part of it has to do with the fact the US Government always seems to be solving near-term economic problems instead of long-term ones, thus delaying the inevitable. Back during the very beginning of the millenium, after the dot-com bubble, and incidents of 9-11, the US felt it could not afford to wait out the recession, and once again artificially stimulated the economy with low interest rates, resulting in rampant borrowing, overpriced housing, and our current economic woes. Further attempts of a similar kind may hide or minimize the problem temporarily, but only lead to an even longer and more painful collapse.
The US economy is sick, and yet the doctor, instead of prescribing rest, pumps more drugs into his patient's body to address the symptoms, then encourages him to continue on. One of these days, the patient may no longer respond to the drugs, his body may crash and he may be forced to rest. Or worse, he may perish.
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