Saturday, September 05, 2009

More thoughts on Krugman and "economists"

Although Paul Krugman's article in The New York Times (Magazine, it turns out) entitled "How Did Economists Get It So Wrong?" seems to fall short of its intended mark, it does succeed quite well at opening up a giant can of worms and encourage people to take a look at what is in "there." The first big question is where "there" really is. Nominally, the article is about economists, which is true enough, but his discourse quickly takes a lot of detours.

I am still gathering my own thoughts, but one thing that appears to be crystal clear: the current financial crisis was a failure of the financial system and its regulation and not economics per se.

There are distinct and separate fields of study:

  • Economics
  • Finance
  • Banking
  • The Federal Reserve and money
  • Non-bank financial system
  • Overall financial system

In fact, as far as I know, there are not even formal fields of study for the latter two critical elements of our economy.

So, a key isue is that there is very little overlap or interaction between the study of economics, finance, and banking.

  • The overall economy assumes a stable banking and investment banking system.
  • Financial evaluation of assets assumes a relatively stable economy and banking system.
  • Banking is supposed to assume that the economy wobbles between boom and bust and asset pricing wobbles between overvalued and undervalued.

There is indeed a common thread that connects all of the fields of our economy and financial system: money. Technically there are multiple threads, with the three most important being:

  • Money
  • Capital
  • Credit

The simple fact is that most subfields of economics assume that money, capital, and credit are stable and ample.

Economists are not complete idiots. They do know that without stable and ample money, capital, and credit the whole economy and financial system grinds to a halt.

That is what happened. There was no way for a pure economist to know in 2007 or 2006 or 2005 that in September of 2008 our entire system of money, capital, and credit would essentially grind to a halt.

But if you had bothered to ask any card-carrying economist back in 2005 or 2006 or 2007 what would happen to the economy if the supply of money, capital, and credit were to completely dry up, every economist, no matter what his stripe would have been able to quickly tell you that of course the whole economy would grind to a halt.

Now if you had asked economists whether they believed that there was a significant risk that the supply of money, capital, and credit might completely dry up in, say, 2008, they would have easily and quickly told you two things: 1) they wouldn't know since finance and banking are not areas of expertise for economists, and 2) it would be highly unlikely since the Federal Reserve would never let that happen.

Sure, there are gold bugs and so-called Austrian economists who would tell you that our system is doomed to repeated crises, but these people have so set up themselves to be isolated from the mainstream that they have essentially no credibility in the mainstream. As the saying goes, even a stopped watch is right twice a day.

Now to be fair, most economists know a little (or more) about finance and banking and financial analysts know a fair amount about economics and banking and bankers know a bit about economics and asset prices, but the general rule is still that each is an expert in there own field and not usually completely on top of the gory details of the other fields. And nobody appears to be an effective expert on the interlinked system of money, capital, and credit.

Now, it it does happen that there was plenty of scuttlebut circulating in 2006 about shady practices in banking and finance, specially with mortage rules, securitization, and leveraging, but the truth is that none of that would fit into any of the formal models used by economists, other than if they were to question a key assumption: are there forces at play that might undermine complete confidence in money, capital, and credit. If people had focused on factors that can impact money, capital, and credit, then maybe the crisis could have been averted.

Or, maybe if the Federal Reserve had a lot more power and a lot more ready capital, the Fed could have more instantly been able to step in and cover supply disruptions in money, capital, and credit, rather than the slow, gradual, piecemeal approach they were forced to use which did in fact work but with such dramatic lags that disruptions in the financial system were quickly able to infect the overall economy in a very dramatic manner.

As the system stands, the Federal Reserve is nominally in charge of regulating money and the private sector nominally provides and self-regulates capital and credit. I am not in favor of changing that per se in normal times, but I am in favor of some sort of trigger that gives the president and the Federal Reserve authority to step in on a systemic disruption of capital and credit on a moment's notice until the private sector is once again able to regain confidence in its ability to supply capital and credit.

As the fields of economics and finance stand today, they have virtually nothing to offer on this matter of assuring stability of the supply of capital and credit.

I'll stop there for now. This topic deserves a lot more thought.

-- Jack Krupansky

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