Friday, December 19, 2008

"I just hope they know what they're doing."

It's just a gigantic scale.... It's the entire economic consensus in this country, including the academic economists, the Treasury people.... We're just taking such big moves. As I say, I just hope they know what they're doing.
- David Brooks, The Newshour with Jim Lehrer, November 28

I also hope they know what they're doing.

And I have major doubts that they do.

Let's start with the contradictions. "The entire economic consensus" used to be that cutting consumption taxes, like Canada's GST, which was just cut another 1% earlier this year, was the worst possible tax cut. Yet Britain cuts its VAT 2.5% and "Jonathan Loynes, chief UK economist at Capital Economics, said: 'This would be a bold, high-impact way of putting money straight into consumers’ pockets.'" Another source says that "[Britain's] economists seem united by a single opinion over the Government's immediate move to slash VAT from 17.5% to 15%. ... The move was, broadly, welcomed, and [even] criticised as not on its own being enough..."

So what was formerly out of fashion, to put it charitably, is now "bold" and "high impact"?

Auto sector bailout? Joseph Stiglitz is opposed, which wouldn't be especially surprising were it not for the fact that Stiglitz has been the most prominent economist to repeatedly jab an accusing finger at the Washington Consensus and free markets generally. Apparently Stiglitz doesn't think the decisions of private finance re the allocation of capital should be second-guessed... except when they should.

The incongruities increase: Germany's Social Democratic finance minister, Peer Steinbr├╝ck, said:
All this will do is raise Britain's debt to a level that will take a whole generation to work off. The same people who would never touch deficit spending are now tossing around billions. The switch from decades of supply-side politics all the way to a crass Keynesianism is breathtaking. When I ask about the origins of the crisis, economists I respect tell me it is the credit-financed growth of recent years and decades. Isn’t this the same mistake everyone is suddenly making again, under all the public pressure?

A supposedly left wing politician, and a Continental one at that, is the voice speaking out against a deficit-financed government spending spree? I'm reminded of when the NDP criticized Alberta's "Conservative" government for its spending. Considering the source, perhaps they have a point?

It is true that there are economists like Greg Mankiw who consider themselves stimulus skeptics, but Mankiw is (1) apparently very much in the minority ("Only one outside economist contacted by Obama aides, Harvard's Greg Mankiw, voiced skepticism") and (2) Mankiw is careful to call himself a skeptic and not an opposer.

There was a time when I put a lot of stock in what academics hold as true with respect to finance and economics. But my experience of the real world of finance disabused me of notions that are still considered gospel for professors, like market efficiency. Markets are not efficient with respect to pricing; they are inevitably subject to manias, panics, and crashes (unless (and even then this is just a theoretical unless) there is total transparency and simplicity with respect to how to determine fundamental values). Indeed, this is at the very core of what got us into this mess: the idea that market-determined prices reflect economic fundamentals. Financial engineers were given free reign to innovate ever more exotic financial products that worked AGAINST efficiency instead of for it by reducing transparency and simplicity. You didn't get better capital pricing with more financial market development, you got worse. Things got further and further away from fundamentals because the trial of bread crumbs became so long and convoluted nobody could understand it.

Now, as an aside, when I speak of market development I speak of the number and complexity of financial instruments (in particular second and third order instruments, aka derivatives) as opposed to liquidity. If I were pointing the finger at liquidity or trading levels, I'd be pointing the finger at capitalism itself.

These academics, in conjunction with the Wall Street veterans who have a conflict of interest with respect to bringing the sort of transparency to capital pricing that would allow non-Ivy League MBAs to figure out what was going on, are supposed to be now be deferred to with respect to a gi-normous dump of future generation financed government spending?

Germany's social democrats are questioning the wisdom of a massive expansion of government, while the Anglo-Saxon world is gung-ho. May you live in interesting times.

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