Response to The World’s Economic Problems are Like 2 Cross-Wired Thermostats

Recently one of my favorite bloggers Harwell Thrasher posted an interesting (and well written) article on economics. Unfortunately, many of the basic assumptions underlying the article are deeply flawed. Since these assumptions are generally believed by the majority of educated Americans I decided to dubunk them here in my blog. For many years I believe these myths too, so by no means am I degrading the great work Harwell does in his blog.

First, there is an implicit assumption that money is a constant scale–-similar to a temperature scale. The exact opposite is true. Money is a commodity with a value that varies greatly over time and place. There are countless examples—a lunch that costs $1 in El Salvador may cost $5 in Tennessee and $10 in New York City. More pertinant to the economic discussion a dollar spent on housing in some markets will buy twice as much house as it did a couple years ago. In general, during recessions the value of money increases dramatically. That increase in value is what triggers entrepenurial activity and re-ignites consumer spending. (i.e. "Wow, this is cheap--I'll buy it." As more sellers and buyers move into the markets the economy recovers.)

The increase in the value of money has a secondary effect of triggering a round of bankrupcies. (It's harder to pay off debts with increasingly valuable money.) Popular opinion labels bankrupcy as a bad thing. It is to the person going bankrupt. But for society at large bankrupcy is generally a possitive. It removes assets from (mis)management that ran it into debt (generally an indicator of future losses) and transfers those assets into the hands of managers who have money to invest (generally an indicator of future success). This reshuffling of wealth into the most capable hands helps lay the groundwork for recovery.

Second, there is an assumption that recessions/depressions do not end without government intervention. Historically the opposite is true. Recessions/depressions are self correcting. (Of which there are numberous examples--three in my lifetime alone and I'm not that old) The only time a recession won't self correct is when government intervenes. Most notoriously Japan’s Lost Decades and our Great Depression. Unfortunately, the Great Depression is so deeply impressed in our collective oral history as a unique event that we don't realize it was simply an ordinary recession that wasn't allowed to self correct.

Third, there is an assumption that recessions are financial events. The cause is actually a misallocation of labor. This misallocation is typically created by a credit bubble that draws resources away from productive activities into pseudo-productive activities. (Usually good activities, but WAY too much of them.) The solution is to reallocate the unnecessary bankers, construction workers and auto workers into productive activity.

The only government solution that might work is education/retraining. The other common government solutions all work directly against the steps needed to recover. Bailouts attempt to keep misallocated workers misallocated. Temporary diversions like building bridges to nowhere and crushing cars are only marginally better since they divert labor into temporary (and wasteful) activities rather than into permanent productive employment. Quantitative easing (printing money) is probably the worst government solution of all. As noted above a deflationary phase is critical to generating a recovery. To the extent that the Fed/Treasury succeed in preventing deflation they prevent recovery. Other financial controls like minimum price and wage controls have the same dampening effect since they prevent entrepreneurial activity from taking root.

From a political perspective the efforts of the Bush and Obama administrations (the short-term economic policies have been similar in both administrations) have been brilliant. However, the economic effect of these policies (if continued) will result in years of prolonged recession. (1)

It’s frustrating to see this happening and know that the 99.9% of American’s are simply not economically educated enough to understand the mechanisms of what is taking place. My only hope is that we will become frustrated enough that we’ll kick out the current leadership team in Washington (Democrats and Republicans) and bring in a new crowd.

1) I have to give credit to Michael Shedlock for introducing me to the concept of an "L" shaped recession--a crash followed by a generally weak economy that doesn't recover. His blog is well worth following.