January 28, 2009

JustQuotes: A First (And Second Zero) For The Fed, Not SocketSite

"The Federal Reserve left the benchmark interest rate as low as zero, said it’s prepared to purchase Treasury securities to resuscitate lending and warned inflation may recede too quickly."

“Deflation is an increased worry,” said William Ford, a former Atlanta Fed chief who’s now at Middle Tennessee State University in Murfreesboro. “They have switched from worrying about inflation to being focused on deflation. It is the first time they have talked about that in a straightforward way.”

Fed Keeps Rate Near Zero, Prepared to Buy Treasuries [Bloomberg]
Did Somebody Say Deflation? [SocketSite]
Promoted From Comment To Post: Satchel Does Deflation [SocketSite]

First Published: January 28, 2009 2:45 PM

Comments from "Plugged In" Readers

There's nothing else they can do except "quantitative easing" aka printing money and buying Treasuries.

The statement is all anyone looked for.

Posted by: jessep at January 28, 2009 3:11 PM

Satchel who ever you are now :) can you re-post your answer to your first post below (from the quick link)...

"What happens when there is deflation? That is, when money/credit is destroyed? And what effects will this process likely have on asset prices, and can certain consumer prices (like food or oil, for instance) still rise in an environment like this, or its variant, what is often thought of as stagflation?
I’ll post more tomorrow. If anyone appreciates this at all"

Yes we or I should say I appreciate it.

Posted by: gowiththeflow at January 28, 2009 3:20 PM

ditto here for satchel. i would appreciate seeing it too.

Posted by: andyc at January 28, 2009 3:39 PM

I would appreciate seeing this from Satchel as well. On a side note, I have never heard such horror stories from associates in construction management as I have in the last two weeks. Six figure managers with 25 years experience and huge portfolios are told there is no more work in some of America's largest construction companies. In Chicago there are now five towers that were under construction that are completely stopped. I was told today that my job was "safe" but this gives small comfort when you know so many friends who are not doing well.

Posted by: Morgan at January 28, 2009 6:27 PM

While I'm not Satchel, here's some info on deflation that might be helpful.


Posted by: DataDude at January 28, 2009 7:35 PM

Satchel's discussion is linked above.

Posted by: Jake at January 28, 2009 7:59 PM

Would be interesting to hear whether Satchel stands by this quote, giving that quantitative easing has just about arrived:

"I would suggest that the moment the Fed atempts a real quantitative easing or hints at monetization, interest rates will spike and cause a collapse of the credit complex the likes of which the world has never seen."

I for one hope this isn't true.

Posted by: Po Hill Jeff at January 28, 2009 8:53 PM

A period of high inflation or deflation.

pick your poison.

Posted by: Paul Hwang at January 28, 2009 9:48 PM

LMriM? I know there is a link but would like to hear directly from Satchel.

Posted by: gowiththeflow at January 29, 2009 2:16 AM

A period of high inflation or deflation.
pick your poison.

Red pill or red pill. It had to happen one day.

I don't know much about all of this but what I understand could happen:

The issue with printing money is that people who buy our debt will want more returns for the decreasing value of our currency. Higher rates will mean more expensive mortgages which will counter the effects of quantitative easing. You'll need more quantitative easing as a result, leading to a spiral.

I don't know if the Fed can manage to do prevent that. I hope they find the right balance, though, without wiping out the responsible folks.

Personally, I'd say just let asset prices drop until they make more sense, which is one big chunk of the problem. Sure there are risks as everyone has bought into the Ponzi from countries to banks to companies to individuals. But we have to bite the bullet one day, right? Pushing it further down the road will only lead to more pain, imho. It's a cancer and painkillers won't do much to cure it.

Posted by: 146 DOM at January 29, 2009 2:33 AM

Po Hill Jeff,

About quantitative easing in the current situation, I think I'd back off that quote a little. I do think that ultimately large scale quantitative easing would cause an immolation of US credit, and would have almost instantly if undertaken back in December 2007. But after crises have raged for a while, some limited quantitative easing (even pretty large scale) can be undertaken without collapsing the USD, but it would severely crowd out private credit. For instance, Japan engaged in quantitative easing after its crises had raged for about 7 years, and the Fed did it during WWII, in each case without immolation.

The crystal ball is certainly getting a bit murky now :), but I do think that large scale quantitative easing (say, enough to monetize the coming deficits of Obamaponzinomics) will fairly quickly disrupt the entire credit system and lead to credit rationing in the private sphere and perhaps total collapse. The situation is a little different now because the USG and the Fed have intervened and seized control of the banks to an extent I didn't think they would. Additionally, the entire developed (and most of the emerging) world is undergoing simultaneous credit crises, and it is even larger than I thought it would be - which also supports the ability to engage in crazy policies.

In the end, though, I do think that the economics (and not the politics) will dictate the outcome. I think large scale monetization of deficits will quickly spiral into a situation where the Fed becomes the lender of first and last resort in a country like the US that does not have high domestic savings rates and a current account deficit. I guess we are all going to find out (if Bernanke is not just engaging in bluster here) :)

Here's a quote from July 2008 that is sort of on topic:

"I agree with the general idea put forth by San Fronzi and others that interest rates should rise given an increase in debt. However, the key is how fast private sector credit is destroyed. In Japan, governmental debt EXPLODED in the 1990s (all the way to 200% debt/gdp) on the back of massive fiscal deficits. Yet interest rates COLLAPSED (all the way down to under 1% for the 10Y JGB) on the back of risk aversion, repatriation of overseas Japanese corporate profits and money printing by BOJ ("quantitative easing" it was called) because private credit was being liquidated (or defaulted) and ALL excess funds found their way to JGBs (BOJ could not print fast enough to offset the collapse in monetary velocity). I think that is a distinct possibility in the US as well, and I am maintaining a fairly large treasuries position because of that."

I do have to say, though, that my view of our future has gotten darker since then. The deficits and policies of the USG that are being contemplated look structural to me, will entail a huge permamnent increase in the regulatory state, and will permanently reduce US prospects. On a medium term view, we are going to get credit rationing, price inflation and much lower standards of living (probably in absolute terms, and certainly relative to the rest of the world). And I am no longer in long term treasuries :)

Posted by: LMRiM at January 29, 2009 6:24 AM

"And I am no longer in long term treasuries"

Do you suppose that will mark the end of bubblenomics?

Posted by: diemos at January 29, 2009 6:37 AM

I hope so, diemos. It would sort of make sense that as you enter a world of generally increasing price inflation and tighter credit that economic activity would tend to gravitate towards activities that more immediate utility than speculative asset bubbles (this world would be the mirror image of the world 1982-2007). Sure, at first, people will try to hold onto the idea that "inflation" will be a subsidy for debt, but you can only fool the suppliers of capital for so long (hence, the "credit rationing" that will come).

Posted by: LMRiM at January 29, 2009 6:49 AM

Sorry if this is a naive question. For us sheep with over 20 years to retirement and not enough savvy to play or time the market, what do you suggest for our 401K's? Stay the course ("market will always rise if you wait long enough")? Get out now and cut losses? Redallocate? Just curious for your insights.

Posted by: trying to make sense at January 29, 2009 7:20 AM

what do you suggest for our 401K's? Stay the course ("market will always rise if you wait long enough")? Get out now and cut losses? Redallocate?

As a sidenote, this "stay the course" is only valid if your job is safe. Life might decide for you what's going to happen.

Think about a friend on the verge of losing his job who bought a house in mid-2007 with 20% down, saw the value go down 30%+ since. He's under water close to 100K and stuck with an incredibly overbloated mortgage. Fair enough, he'll suck it up. But he stayed the course on his 100% stocks portfolio (that's what you should do in your mid-30s, right?). He keeps contributing and that's fair, just averaging down. More like hemorrhaging down. He's down about 40-45%.

In 2 years time his savings have been wiped out by Real Estate and the subsequent market correction. Now his joob in on the line. Freaky triple-whammy situation from someone who has followed all the rules and the advises of the "smart money".

I wonder how the multitude of hard honnest workers now stuck into this mess will get out of this?

Posted by: 145 DOM at January 29, 2009 8:38 AM

145 DOM: The way your friend gets out of this is by doing what I would do: letting the endless gnawing anxiety about finances turn you into an insomniac who is on the verge of being a raving lunatic due to lack of sleep, and someone who can no longer function at work or in society.

That or you get a prescription for Ambien and just tune out until all the badness goes away.

So you can try as hard as you want but in the end, sometimes the economy just kicks you in the nuts really, really hard & you gotta cut your losses and start over.

Posted by: Jimmy (Bitter Renter) at January 29, 2009 9:21 AM

what do you suggest for our 401K's?

Just some general ideas, but I'll tell you approximately where my IRAs (no 401(k) anymore - I retired 10 years ago) are right now. I trade reasonably actively in IRAs, so I do change, but I try not to make rash changes or "overtrade":

50% cash (or equivalent)
10% Ginnie Mae
10% US stock indexes (reallocated to 10% in summer 07)
10% foreign stocks (emphasis on Asia)
10% foreign sovergeign bonds/gold ("paper" ETFs)
10% miscellaneous individual stocks, junk bonds, etc.

Generally, if you are still working (earning USD), I think you want to have substantial foreign exposure. I like increasing exposure to Asian equity indexes, slowly over the next 2-3 years. I very much believe in reallocating every year or so (maintaining target exposure percentages) and in changing targets as macroeconomic conditions change.

I don't expect US stocks to fare very well over the next decade; however, at these levels it would not make sense to liquidate entirely. If you are very heavily exposed to US equities, I'd pick a mechanical schedule to reallocate a small portion out - perhaps every month or quarter - to get to a target allocation that makes sense for you. I'd guess for most people 20% would be about the most I'd want in US stocks (I'd want to have larger Asian equity exposure when all is said and done than US exposure). Some cash makes sense here, but high yield bonds seem a pretty good bet for a small percentage (say, 5%) of assets, especially to the extent it replaces equity exposure.

I suspect I will get a little more bullish on medium term prospects for US stocks pretty soon (I'm not really too bearish right now), but I do think the next 10 years are not going to be "fire and forget" or "buy and hold" type years. The last 10 certainly haven't been, and I think that dynamic will continue (similar to the market dynamic that prevailed 1966-early 1980s). On a true wipeout of course (say, S&P below 500, relatively quickly), I'd be a big buyer on a 1- to 3-year view.

I am a little out there of course with my views, but as a general matter I wouldn't want to put too much in 401(k)s or IRAs. Of course, it always makes sense to put in enough to get any company match, but I doubt the structure will look so attractive 20-30 years hence. Either there will be some sort of means testing, raising of tax rates, forced conversion of part of it, or a combination of all three, by the time all is said and done. It is just too large a pool of money for the politicians to leave alone. Just my opinion of course, but I am planning to take advantage of any opportunities (either low income years, or special withdrawals already kicked around to allow people to cash out portions penalty-free) to liquidate IRA balances. I think the cash is better deployed in either income producing real estate (where values make sense) or in a small business (if you have the inclination) than stuck in a creature of tax regulation for 30 years. 10 years is probably fine :), but a lot can happen in 30 years.

I hope all that rambling helps! (Obviously, I don't want to recommend specific investments, and really no one should without knowing the particulars of someon's financial situation and how 401(k)s and IRAs fit into the overall financial picture.)

Posted by: LMRiM at January 29, 2009 9:29 AM

"Either there will be some sort of means testing, raising of tax rates, forced conversion of part of it, or a combination of all three, by the time all is said and done. It is just too large a pool of money for the politicians to leave alone."

LMRiM, this may be the most insightful thing I've ever read from you, and that's saying something. A truly excellent point. Thinking about it now, a means test for Soc Sec payments based on 401k balances could easily be floated as a "solution" to the pending SS crisis.

Posted by: Foolio at January 29, 2009 9:45 AM

Thanks. The rambling insights do help. Of course did not expect specific recommendations.

Posted by: trying to make sense at January 29, 2009 9:58 AM

The situation is a little different now because the USG and the Fed have intervened and seized control of the banks to an extent I didn't think they would.

I told you that you were an optimist. :)

And I am no longer in long term treasuries :)

and you are now seeing MY light! :)

I'm just ribbing you of course.

The crystal ball is certainly getting a bit murky now :)

I'm glad you finally joined me in the murky-crystal-ball club.

Posted by: ex SF-er at January 29, 2009 10:16 AM

LmRim, et al-

I agree that 'quantitative easing' is an inevitability, especially w/a $800+ billion stimulous plan...which i bet will be signed into law by mid-feb.

I guess if we're lucky, there will be some 'stimulation' to the economy by mid summer. And depending on how the bond markets react, as well as the level of nervousness of foreign gov's buying our t-bills yielding

Which leads me to believe that chaces are pretty good that we will have a "W" recovery/trajectory as inflation sets in on the second part of the W.

What i'm wondering about, as owner of investment property, is if that inflation will be 'good' or 'bad' inflation (gotta love that :). I.e. Good inflation, which i define as orderly, will serve to increase the income as well as value of my property portfolio. Perhaps my definition of good inflation needs refinement, so folks feel free to chime in on this. Again, the crux of the issue is: what is 'good inflation' and how it can benefit the owners of real assets.

Posted by: 44yo hipster at January 29, 2009 5:57 PM

The only 'good inflation' for property owners is wage inflation which allows renters to pay more rent and borrowers to borrow more money. Goods inflation without wage inflation reduces the amount of money that can be spent on rent and mortgages.

Of course, the best inflation for owners is asset inflation, which is what we just lived through. But you have to time it right. Asset inflation only lasts as long as loose lending is in force and reverts to mean once the lending standards tighten. Don't expect to see this kind of inflation again in your lifetime.

Posted by: diemos at January 29, 2009 7:46 PM

Diemos- in most steady/controlled inflationary times incomes go up. This has happened in israel in the eighties, in argentina post y2000, etc. And those situation benefit property owners greatly, as their assets are usually leveraged. Especially so of they have decent fixed rate mortgages.

This is diffetent than what the usa had in the 70's- stagflation. I'm imterrsted in explorimg the myraid of conditions tjat differentiate the two scenarios.

Posted by: 44yo hipster at January 29, 2009 8:58 PM




Posted by: Paul Hwang at January 29, 2009 11:39 PM

Market Ticker had a fun piece today about monetization, quantitative easing, etc., and even touches on the CDS issue. (First part of the article is market technicals.) He's always a little over the top, but always well worth reading:


Posted by: LMRiM at January 30, 2009 8:16 AM

S & P 500-550 would be historical P/E lows?

Posted by: Paul Hwang at January 31, 2009 1:07 AM

S & P 500-550 would be historical P/E lows?

No, not at all. I don't have all the data readily available, but 1982 saw p/e's around 7. Earnings quality was better back then (less accounting gimmicks, less corporate leverage goosing the numbers), dividends were much higher, but of course interest rates were higher too.

Who knows where earnings for 2009 will come in, but it's looking fairly certain that it will be under $50, perhaps significantly lower. That would be a p/e around 10 at S&P 500-550. Hardly expensive, but not the lowest it's been. At 16x forward guesstimates, the S&P 500 currently (830 level) is not cheap historically, which could be pretty bad news.

Posted by: LMRiM at January 31, 2009 7:29 AM


Thanks for the mkt ticker link. It seems that the thing keeping a number of insolvent institutions from being declared bankrupt are the accounting tricks.

Amoung the dirty little secrets, and one of the root causes of the calamity, I think is this idea of synthetic debt.

If I've got this right as an observer, it goes like this (and this may have been said before): individual mortgages were bundled, sold to investment banks, (mis)rated by the rating agencies giving them a false sense of (low) risk, repackaged and sold as bonds (MBS, CDOs etc) to investors. With nice transaction fees all along the way.

At this point the debt was still collateralized by the properties themselves, at least giving them some value should the bottom drop out of the market, as it did and continues to do.

In addition, however, these end investors also bought insurance on their investments (CDS) from the likes of AIG (so-called counterparties). These unregulated insurers, while making a lot of money with these financial products, did not have any collateral behind their products and were enormously leveraged - given that they had no margin supervision -relative to the value of the bonds they were insuring.

And this is the synthetic debt that is now worthless paper, b/c these insurers cannot pay what they said they could in the CDS contracts.
And this is the unlimited risk that's now being realized.

That said - most of which may appear obvious to yourself or others - what to do with this information from an investors standpoint.

Do you short all who you suspect are going down and, if so, through what trading vehicle. Or are you waiting to see how what moves the govt decides to play to attenuate what appears to be an eventual collapse and restructuring of a lot of these companies and investors.

Posted by: Amir at January 31, 2009 11:08 AM


Since there a possiblity that Cali will start paying it's employees in scrip I was wondering if a secondary market in them might develop. Do you think the state will accept their own scrip for taxes and fees. Will it be worthwhile to buy some scrip at a discount to pay the state in? Will we see gresham's law in action?

Posted by: diemos at January 31, 2009 5:35 PM


That really would be a good laugh if they started paying employees in scrip. I'd expect it to trade at a discount to implied forward rates of the muni debt, but I doubt it's ever going to happen. The child is just stamping its foot, so daddy Washington gives it a lollipop. The secondary objective of this whole farce is to soften up the citizenry for more confiscatory taxes, which will simply be pissed away.

When I was a kid, a lot of people around me had food stamps (the paper kind - not the credit card lookalikes they give out now) and they traded at a discount to cash - can't remember what the ratios were, but I remember well shopkeepers extending the prohibited items (cigarettes, liquor, etc.) to the food stamp holders at a premium to the stamps' value. Bronx, mid-1970s.

This is actually on topic about deflation versus monetization. I came across a pretty interesting discussion of the dynamic between debt deflation and monetization that's worth reading. It's a somewhat more elegant treatment of the intuition that it is not going to be within the realm of political possibility to print enough money to offset the collapse of private credit, and is based on the idea that the monetary base doesn't generate credit-money (through a multiplier, but rather that banks' and private parties' wilingness to create credit-money drives increases in the base. By forcing the base higher, Bernanke is trying to ue the tail to wag the dog.


I haven't worked through the theoretical model and literature cited but it seems pretty interesting, and suggests that Professor Bernanke's reading of the Depression history is fatally flawed because it is viewed through a faulty model (neoclassical money creation). Nothing that we haven't seen or considered before, but I hadn't seen it put this way exactly in one treatment. The (slightly) more theoretical treatment of the model is here:


I'd be interested in your thoughts on the article and paper if you get around to reading them, and it actually would be on topic for this thread :)

Posted by: LMRiM at January 31, 2009 6:59 PM


To answer your question, the last time it happened, most banks just accepted it at 100 cents on the dollar. The banks wanted to hold on to their account holders, so they just sucked it up and ate the interest lost. The banks held the IOUs and cashed them when the state finally agreed on a budget. One bank made the announcement to try to steal depositors from the others, and the other banks quickly followed suit.

Today, short term interest is effectively at 0%, so the banks will be more likely to take the hit.

It's good thinking, though. I myself have been thinking about cornering the market on "Daylight Savings Time". The states would agree to forgo springing forward for a few years, and I would buy up the rights. Then, I'd "spring forward" by several hours all at one time, trade stocks ahead of the tape before anyone caught up, and make millions of $. I'm having one heck of a Y2K-type computer problem implementing it or I'd do it in a heartbeat.

Posted by: tipster at January 31, 2009 10:18 PM


Yes, the first link closely mirrors my own analysis of the system. (I guess I don't need to take a year off to write a book after all. ;) )

Credit creation is the master positive feedback loop that creates the business cycle. Extending credit moves economic activity from the future into the present, creating first boom as credit expands and then bust as it contracts. Government interventions to create an eternal boom by endless credit expansion just drives the system further from equilibrium and ensures that the bust will be more horrific once it arrives.
(As an aside, fractional reserve lending isn't the villain people like to think it is. You get the same effect if individuals directly loan out their excess money as if they hand their money to a bank to loan for them. Any form of credit creation will have the same effect.)

So where credit creation artificially stimulated economic activity above it's equilibrium level, credit contraction will artificially suppress economic activity below it's equilibrium level. Rather than reallocating resources to more productive uses you can easily get into the situation where resources sit idle and go unused. (i.e. the classic GD example of farmers plowing under their fields while the cities starve. Houses sitting empty and decaying while people live under bridges.) With insufficient credit worthy borrowers or projects there's no mechanism to put money in people's hand in order to stimulate demand and put those resources to work except to wait for prices to fall which is fiercely resisted on many fronts.

Letting resources sit idle because of a lack of money to create demand is non-optimal so what's the right policy response?

Fiddle with interest rates and reserve requirement? A lack of worthwhile borrowers and projects makes that futile.

Tax and spend? Doesn't create any money, just changes what existing money get's spent on.

Borrow and spend? Does create economic activity by having the government become the borrower of last resort but just puts off the day of reckoning and makes it worse once it arrives.

Print fiat and spend? Does create money and economic activity but tends to create non-optimal economic activity that will end once the stimulus is removed.

Print fiat and distribute? Yup, print up money and hand it out to the people. They will spend it on what they want and create economic activity that is actually useful to them. Of course, this can only be a temporary response while credit-money is contracting. Attempting to continue it after the contraction is over will only create inflation which will have no beneficial effect.

However, since this would take the benefit of seigniorage out of the hands of the banksters and put it back into the hands of the people it will never happen. Instead the elite will heap untold misery on the people in order to maintain their privileges.

I'll take a look at the second link later. Cheers.

Posted by: diemos at February 1, 2009 10:15 AM


The second link is an interesting quantification of the model. But I don't look at it and say "We're doomed to deflation." Like I've said before, my view of the economy as a system is influenced by my experience in designing feedback and control systems. I look at those equations and say to myself, "Well. The system is broken. So what do I need to change in the equations to get stable operation and the results I want."

So what are my design criteria? I want a system that will:
- provide every one with a minimal allocation of resources to feed and house themselves regardless of their employment status
- reward productive activity with a greater allocation of resources
- automatically inject money into the system when economic activity slows and withdraw money from the system when economic activity increases.
- achieve the absolute minimal distortion of free market allocation of resources to productive uses.

To do that I would:
-Institute guaranteed income. $10,000/adult citizen/year straight off the printing presses.
-Balance the money printing with money destruction. 20% flat tax on all earned and unearned income, capital gains, etc.
-Eliminate every single social program in existence. No aid to dependent children, food stamps, medicaid, downpayment assitance, medicare, pell grants, etc, etc, etc, etc, etc. The $10,000 a year is your share of societies wealth. Spend it on food, spend it on housing, spend it on hookers and blow, whatever, it's yours to spend. Government is reduced to it's fundamental job of ensuring that citizens are secure in their person and their property. Government expenditures summed over all levels limited to 10% of GDP.
- Since the guaranteed income is fixed and the tax varies with economic activity it automatically injects and withdraws money as needed. Eliminate the central bank.

I've always been afraid that if I posted these ideas it might give the Austrian's on the board an aneurysm on the spot, but, there it is. Worker's of the world unite, overthrow your bankster overlords, you have nothing to lose but your 401Ks!

Posted by: diemos at February 1, 2009 7:11 PM

Diemos, LMRIM,

I like Keen's work very much, but I would clarify Deimos' reading of it. I'll be a bit quick and rambling here, but this thread is old, and the discussion is on-topic.

The key point is that there are multiple equilibria for interest rates -- not one, and that the equlibria are unstable*. You don't need government meddling to cause instability, anymore than a ball rolling off a hill is caused by government fiat. The market is simply unable to keep interest rates at a given equilibrium point conducive to positive cash flows and bounded debt to output, because the dynamics don't allow for it.

This is the exact opposite of the various loanable fund fictions that assume that that there is a supply schedule of funds and a demand schedule, and that the interest rate is the intersection of two monotonic curves that are independent of each other. In reality, there are feedback loops that are simply ignored by neo-classical (as well as Austrian) economists. As a result of these feedback loops, periods of lower interest rates will tend to drive the rates even lower, and periods of higher rates will drive the rates higher. Interest rates have "memory" or trend following. The schedule of money to invest is not fixed, but expands with hope, and shrinks with pessimism as the prediction markets swing between the optimism and pessimism.

The Austrians were simply unable to explain this, and instead decided that there must be some external forcing function causing the swings from boom to bust -- government. They were unaware of dynamical systems and the possibility that stable equilibrium points may not exist. Or perhaps, politically, they were not willing to consider the possibility that financial markets may not be as stable or rational as goods markets.

The statement that interest rate equilibria are unstable is a deep statement. One way of looking at this is that there is trend following in prediction markets. I.e. In a bull market, the capital of bears shrinks, and that of bulls increases. So, prediction markets are inherently pro-cyclical.

But, there is actually a simpler way to view the dynamics of the debt to output ratio without the need for a full blown Minsky model that incorporates things like philips curves and aggregate production functions. Instead, looking at nominal cash flows, debts, and interest rates is sufficient. Specifically, if A is the ratio of (nominal) debt to output, then you have

dA/dt = z + (r-g)A

where z is the fraction of output realized by those with capital in the real economy (i.e. the fraction of national income that is realized as operating cash flow of businesses or household savings of those entities that have net assets), r is the realized debt service rate on the entire debt stock, and g is the growth rate. All terms are functions. It is simple to derive this from a credit model of money -- and no need to differentiate between business and households, but rather between those with net assets and those net debts.

Because of the scaling factor, A, any mismatch of the term r-g can cause wild instability in A. In particular, a period of time in which z is positive can force A higher. Once A is higher, the slightest deviation from the (constantly changing) optimal value of r will cause the debt to output ratio to expand or collapse.

Moreover, and this is also a critical ingredient, cash flows (z) are very volatile, whereas real returns (as well as g) are rigid and slow moving. It is not a question of the current market rates, but the realized rate of the entire stock of debt. It is difficult to change this value and re-negotiate all contracts as cash flows rise or fall. In fact, many economists remain puzzled as to why nominal effects matter. Simply put, the rigidity of the realized rates accounts for much of the importance of nominal issues.

The only way that A will remain bounded is if the realized rate of interest is *less* than the economic growth rate -- i.e. asset holders obtain a proportionally smaller share of output with time.

So what happens, is that the debt to output ratio will continue to rise until r drops significantly. This drop can occur by defaults and foreclosures, or by re-negotiation (or say, the government declaring contracts to be invalid, or printing money to retire debt). The question is, how to bring r down without destroying output and employment. Financial asset values must be destroyed (by definition), but we want to destroy as little as possible in the real economy when this happens.

Note that things were just as bad in 1960 as they are today, but we were earlier on the exponential curve than today. The same dynamic was in effect then, too. It is *always* in effect. We have not been on some debt binge as a result of Greenspan. That is a superficial, political view of the dynamics. The fed as currently run, is just not that important. The only meaningful government intervention which could affect this cycle would be to lower z (say, by high taxes on profits) *very* early in the cycle (before A is large) and to force write-offs or debt renegotiations, for example by actually enforcing strict leverage requirements on banks. But the fed funds overnight lending rate is simply not a factor for debt inflation or deflation. Note that the rate hikes by Volcker happened in an environment in which banks were regulated so that that reserve requirements were real, therefore the rate hikes actually shrunk credit growth, which was not the case in Greenspan's time.

So any period of positive cashflows will kick off an exponential growth relationship in debt to output, that will only end in negative cash flows. It is z -- the accumulation of money itself by creditors -- that is the "forcing factor" unleashing an unstable dynamical system.

Government comes in to try to bail out the economy when the collapse occurs. I.e. it is the natural instability of the financial markets that forces government interference, not the other way around.

(*) technically, there is a small region of stability -- in the flow equation I outlined, if A is very small, Z is volatile, but small, and both r and are relatively constant, then A can remain roughly flat. I.e. an economy with low and often negative profits, low growth, and low interest. In fact, as the economy becomes more "medieval" and profits shares go to zero, the region of stability grows and interest rates have more wiggle room.

Posted by: Robert at February 1, 2009 7:20 PM

Cogent analysis is always welcome Robert.

Posted by: diemos at February 1, 2009 7:36 PM

Robert and diemos,

Thanks, and that's interesting analysis from both of you (and policy prescription from diemos). I'm just getting back from a Superbowl party, so now is not the time for a full discussion, but one thing that immediately strikes me from both your discussions:

Perhaps understandly (because you are both scientists/engineers), you both seem to look at the inherent instability of the cycles as something that needs to be "stabilized". Thus, you view (Robert more so than diemos) declines in output and "idle resources" due to supposedly insufficient demand as things that are negatives and which must be avoided. While I agree that large scale disruptions in output and resources are something to be avoided, I'd suggest that rather than trying to eliminate the cycles (which serve the important function of determining which activities are most useful to society and which resources need to be liquidated or reallocated), the best practical approach is to figure out the system that is less likely to lead to coordinated boom/busts across industries/productive activities, so that the falls are not as dramatic. I think that is consistent with where the Austrians come from.

I don't think that the Austrians would disagree at all with Robert's observation that natural interest rates are unstable, or that there is some serial correlation in rates (trending). I think, though, they would argue that the presence of a central bank that steps in to provide lender of last resort financing or attempts to manipulate the particular level of rates through expansion of the money supply will in general lead to the type of large scale coordinated booms and busts that we want to avoid.

(Robert, the Fed has done much more than simply regulate reserves and influence Fed Funds through OMO. For instance, the Fed was critical in encouraging and coordinating the spectacular increase in the asset backed securitization markets in the 1990s. The Fed (and Treasury)also "greenlighted" breakdowns in long standing regulatory schemes like Glass Steagall in the 1990s and also stepped in repeatedly to backstop foolish gambling schemes like sovereign lending to Latin America in the 1980s through LTCM and Bear Stearns/AIG/money center bank insolvencies today.)

From the economic actor point of view, smaller and more frequent liquidation events should lead to less willingness to expand credit/undertake marginally productive activities, and this should lead to some natural limitation on the propensity to expand credit beyond the real productive capacity of the investments, the tendency as Robert notes to expand credit as a result of the profit function. Conversely, the presence of the central manipulator of rates strengthens the perception of riskless investing and credit expansion, leading to large scale structural misallocations of productive resources due to credit.

The argument about government (fiscal) intervention is of course a little different. This is of course obvious to both of you, but government is unlikely to spend money in an economically efficient manner, as its priorities are political in that it appeals to every voter's natural desire to take advantage of an externality. So, the larger the share of economic activity that is organized according to political priorities (either direct taxing and spending or misguided regulation), the less productive the economy is and the lower potential and realized output would be. Of course, there must be some idea akin to the Laffer curve here - up to x%, government regulation and intevention is helpful and beyond it it begins to become increasingly harmful to output. The Soviet Union never officially had a recession (no fall in output) until it collapsed :)

I have some ideas about this "let's not let resources sit idle" but maybe we can pick this up later, when the effects of the Superbowl party have worn off :) Thanks again for your thoughtful posts.

Posted by: LMRiM at February 1, 2009 8:56 PM

LMRIM/Satchel/Our resident Austrian Economist,

I'm a bit drunk now, but will make some comments:

you both seem to look at the inherent instability of the cycles as something that needs to be "stabilized"...

You may want to look at the Minsky FIH dynamics presented here:

The question is not, do we "avoid" cycles with government intervention. Without intervention, the cycles are rather large. In fact, they blow up -- there is no reason to believe that a return to the "good" equilibrium point will occur in our lifetime, or in our children's lifetime. Note the (global!) "Long Depression" of 1872-1892 -- and without massive inflows of gold from Alaska and europe, it might have lasted much longer. Why do you believe that less time should be spend at the "bad" points than at the goods ones? The Roman Empire, after all, was a capitalist state with a banking system that devolved into medieval feudalism and was basically stuck there for 1000 years. That one had a lot of pro-cyclical actions by the emperors, though, particularly when they tried to guarantee debts, and then hold entire villages accountable if defaults occurred. Credit was only available to village leaders, and quickly became hereditary due to trust issues.

With counter-cyclical government intervention, the cycles are not overcome, they are exacerbated -- but bounded. I.e. with a Minskyan counter-cyclical approach, you have more instability, but the return to the "good" equilibrium point occurs much faster, and the deviation is less in magnitude. You pay a cost of more recessions and higher inflation. No one is trying to tame the business cycle here -- that's Friedman. Minksy loved the business cycle, in particular stagflation, because it kept asset prices low, and kept us away from the debt bubble. It is also good for market discipline.

the best practical approach is to figure out the system that is less likely to lead to coordinated boom/busts across industries/productive activities, so that the falls are not as dramatic.

Again, left to themselves, the financial market will cause coordinated booms and busts. That is the point of instability. This is not caused by government, anymore than the coordinated periods of growth are.

By definition, periods of optimism and pessimism are industry-wide (and global), and this has always been the case. I would refer you to the Rogoff paper I cited earlier, which documents 200 years of coordinated booms and busts, in which >50% of the nations of the world were in simultaneous mass default. These booms and busts appear regularly, and are correlated to high capital mobility. This is not the fault of the federal reserve, and is the consequence of the system dynamics, not of government interference.

Again, the trade off is massive booms and busts (without counter-cyclical government), or more frequent "stagflations" and recessions (with counter-cyclical government). Of course, pro-cyclical government enervates the situation.

From the economic actor point of view, smaller and more frequent liquidation events should lead to less willingness to expand credit/undertake marginally productive activities, and this should lead to some natural limitation on the propensity to expand credit beyond the real productive capacity of the investments

What you are saying here is that it is a stable equilibrium. That a displacement from it will encounter negative feedback in the form of smaller liquidations. This is not the case.

Namely, during the boom, liquidations don't happen because assets can still be sold at a profit. Therefore the low cost of failure encourages additional risk taking (and profit taking). Liquidations only happen when the boom ends, at which point it is too late, and we devolve to a different rate of return, hopefully not "0", but possibly so. We may stay at the new rate of return for as long as we were in the "good" rate of return -- or longer. There is no reason to believe that things only go up. In other words, you are still not appreciating that there are multiple unstable equilibria.

This is of course obvious to both of you, but government is unlikely to spend money in an economically efficient manner, as its priorities are political..

There is a lot to say about this. I think, the situation is more complex than you let on here, and touches on the limits of economics. It's hard to predict what is efficient and what is not, and the answer has much to do with social capital, national "energy", a sense of purpose and of community, and luck. These factors are not controllable, or explainable with ODEs or ideology. Was the interstate highway system a productive use of funds? I honestly don't know. The jury is still out on that one, as it is on almost everything else. I would point out that England's Golden Age of the Victorian Era, together with America's Golden Age of the 1950s were both marked by enormous levels of taxation, a military industrial complex, oligopolies, price-fixing, and a "managed economy". In fact, aside from commodity exporters, no nation has ever been an export power without being a managed economy -- one that stifles dissent. No nation has ever industrialized without undergoing rampant corruption, price-fixing, restrictions on personal freedom, and a massive expansion of the government and banking sectors. Not a single one.

Productivity is determined by people's output, and it is not determined by the ownership structure of their workplace, or by aggregate factors such as the income tax rate. It is hard to control and harder to predict, and does not fall neatly along ideological lines. There is evidence that productivity is linked to median age and rule of law -- who knows, maybe marital status as well. There is zero evidence that productivity is linked to the share of government as a percentage of GDP, or to low capital gains rates.

I personally believe that the U.S. is currently a nation infested with isolated incompetents that rob each other in the private sector and play solitaire in the public sector, but this does not mean that one is better than the other. There were other times in our history when things were different, and we may see those times again. If we do, it will not be because of Austrian ideology, or any other ideology.

One more thing,

Keen points out that 1 oz of gold, invested in 0 A.D., yielding 3%, would be worth more than twice the earth's weight in gold in 2000 A.D. (or equivalent -- too drunk to look it up now). The point is that things will not continue to grow exponentially. Population will not, and neither will capital. Between 0 A.D. and 1600 A.D., income was basically stagnant, at $500 per year. Less than in pre-agricultural days, when measured by factors such as the height of skeletons.

Money accumulation only works if those who earn a profit re-invest that profit to their debtors, preferring instead a steady stream of payments. This stream of payments is only possible in an environment of exponential growth, in which others divert their consumption to us, in the hopes of also obtaining streams of payments from the next generation. Population growth underpins this. If and when we realize that this is a ponzi scheme, that if we all tried to sell those payment streams, that there would not be enough goods to match the claims on them -- then the game is up. At that point, we are near the "0" unstable point, and it may well be a very long time before credit starts flowing again.

There is no reason to look at the exponential jump from 1800 A.D. to 2000 A.D as anything other than an anomaly. It may well be that when capital accumulation reaches its saturation point, that we revert to constant returns, or at least linear returns, and come to view the mass era of industrialization as a step function in our history.

Posted by: Robert at February 2, 2009 4:18 AM


So many interesting ideas in your post, as always. I'll post some ideas and reactions later (not comprehensive - there's too much good stuff there, and I'm not the guy to dispute all of it!).

Posted by: LMRiM at February 2, 2009 7:07 AM

Still no response from LMRiM? Damn, I was looking forward to it...

Maybe this bump will help ;)

Posted by: Brutus at February 4, 2009 10:45 PM

OK, Brutus. I had written something, but I thought it might be best to just let the thread die. However, due to popular demand, I'll post what I had written (sorry for the length and incoherence - if I had had more time, it would have been shorter :)).

Posted by: LMRiM at February 5, 2009 6:33 AM

Always many interesting ideas, Robert, and I really couldn't do your post justice to discuss all of them (even if I could discuss them all cogently!). But I'd just offer a few observations/comments about your examples of “coordinated busts” and government share of GDP.

You bring up the long depression of the 1870s-90s in the US. But isn't this period really an example of the resiliency of the system and the ability to recover quickly as regards real output?

I'm not the world's expert in the period, but the Panic which began it (1873) is most often viewed as a credit revulsion that flowed from the rampant inflation of the Civil War ("greenback") period of fiat money, combined and exacerbated by a (perhaps unrelated) European banking panic and collapse, partially as a result of real estate speculation and partially because of the status of the US as an export powerhouse, which undercut traditional agricultural and commodity supplies in Europe (sort of like the role China plays today in a very rough way as regards manufactured goods).

Nevertheless, wasn't there a spectacular boom in the US in the 1880s, centered on finance of railroads and the massive gains to agricultural and industrial/transport productivity? Unemployment was virtually nil in the 1880s (it did rise significantly in the 1890s, especially as the labor intensive agricultural sector was forced into massive productivity improvement and labor shedding by the general deflation of the period), but overall, far from being the "Long Depression" characterized by massive price deflation that the period is traditionally referred to, wasn't US GDP growth and living standard increases the fastest in its history over this period? (4%+ average annual GDP growth over the whole period between the Panics - just going from memory here, so I may be off a little) I'd think that it's hardly an example of a coordinated bust that led to 0% (or negative) returns!

About government spending in the 1950s, say, I think that you are mixing some ideas here. Sure, Federal taxation and government share of GDP were fairly large, but state spending and taxation was fairly low, and the combined share of GDP represented by government was significantly lower than today, say. Probably only about 60-65% of today's combined share, on average (I don't have the latest data handy from the BEA NIPA, but see this chart here - http://carriedaway.blogs.com/carried_away/2003/10/us_government_s.html).

In addition, we need to look long and hard at the character and composition of government spending. I'd never argue that all government spending is useless, just that it is likely to be inefficiently allocated. In other words, the interstate highway system may have been more efficiently undertaken by private consortiums, but no one would doubt that it had (and continues to have) real value in the chain of production/activity. (Perhaps this idea could be expanded to Roman history - as much of Roman history can be characterized by an increasing focus by the emperors on unproductive uses of larger shares of the empire’s resources, namely warfare and welfare for increasing numbers of urban residents - but maybe this is stretching the history too much, and I'm not a super expert in Roman history either! :) ).

Today, I bet that the share of government spending (from state and Federal sources, which is of course the only way to look at it) that represents 3 line items practically exceeds the entirety of government spending in the 1950s: social security, Medicare/Medicaid and public education. Both the former programs are of course pure welfare transfer payments, and it’s hard to argue we are getting much for the last, as I’ve seen stats that show that the public spending on education has tripled in real terms (per pupil) since 1960, with ZERO increase in actual benefit (perhaps even negative!) in the public screwal system since then.

Robert, it would be too long to get into all the ideas in your piece, so please forgive my not addressing all of them. Perhaps on January 1, 2012 (the “diemos date”), there could be a thread and even perhaps a get-together dinner for all of the SS armchair economists organized by our host (at least those of us who are still in the Bay Area). I’ve seen things like that on other blogs. I hope the “diemos date” idea gets some traction, at least or a thread at that time.

The only other thing I’d really like to address is your implicit idea that money capital is the only (or primary) spur to growth, such that you are extremely concerned that an accumulation of money capital without a coordinate increase in price level and money supply would lead to hoarding and the shutdown of economic activity towards medieval standards. Capital is just one factor in spurring productivity, and perhaps not the largest. I think you stretch the historical analogies too far – the Roman Empire didn’t fall because of a central bank and even *I* wouldn’t blame the Fed for the decrease in skeletal sizes after the Medieval Climate Optimum :) GDP as well is an incomplete proxy for productive activity of an economy. I’d actually argue that the simple ability of people to see a return from their labor (i.e., to increase their living standards by keeping the fruits of their labor and having defensible claims to private property) was a larger reason for “progress” since the Enlightenment than even capital and credit systems. I agree with you that nothing is etched in stone, and progress is not guaranteed.

Posted by: LMRiM at February 5, 2009 6:35 AM

Thanks to LMRIM, Robert and diemos for the discussion.

Posted by: R at February 5, 2009 3:45 PM

Yes, a good discussion. I'll let LMRIM have the last word except to say that a Socketsite get-together is a great idea, particularly if it happens at a bar. I'm a fan of the Sazerac.

Posted by: Robert at February 6, 2009 2:01 PM

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