Sunday, September 19, 2010

Rebuking Economics: The Clothes Have No Emperor

Economics is often called the dismal science, but it is, in fact, a spectacularly brilliant and methodical lie.  Tailored to fit a reality that does not exist, economics nevertheless manages consistently to point the finger of blame at the ordinary citizen (now the “consumer” in America) whenever a completely foreseeable “unforeseeable” economic disaster occurs.  But the consumer is no more sovereign in economics than he has in business.  While consumer sovereignty in business has been called a form of “innocent fraud,” consumer sovereignty in orthodox economics cannot be:  fraud, yes; innocent, no.  The cloth of economics has been carefully spun to fit a straw man while hiding the true sovereign from sight.
Orthodox Economics "Disappears" Debt-Financed Speculation (and the Instability it Causes)
Steve Keen is a heterodox Post-Keynesian economist who has committed himself to debunking orthodox neoclassical economic theory, which dictates economics policy in the United States and his native Australia.  In his book, Debunking Economics: The Naked Emperor of the Social Sciences, Keen lays bare the absurdity of neoclassical microeconomics.  At his blog, Debtwatch, Keen routinely lambastes neoclassical macroeconomics and its adherents, primarily using dynamic mathematical models based on Hyman Minsky’s Financial Instability Hypothesis as extended by Keen’s own work.  In a nutshell, orthodox economic theory ignores money in microeconomics, debt in macroeconomics, and banks entirely.  Since banks and debt don't exist, debt-financed financial speculation doesn't exist.
Heterodox Economics Recognizes Instability Caused byDebt-Financed Speculation But Seeks Only to Contain It
While Keen is to be admired for his earnestness and perseverance in attacking the economic orthodoxy, his own economic theory suffers from an “innocent fraud” in that it relies too heavily on the concepts of aggregate supply and demand originally developed by John Maynard Keynes.  Such aggregates tell only part of the story while discouraging a deeper analysis of available data.  For example, in an excellent recent post, Keen sets forth his theory that annual aggregate demand is determined not by GDP alone, but by GDP plus the aggregate annual change in private debt.  He then proceeds to explain the correlation that he has discovered between unemployment rate and the rate of change in aggregate private debt.  There was only one problem with using the aggregate, and that is the underlying assumption that a dollar borrowed is a dollar spent in the economy.  The problem with this assumption is that a dollar boworred to speculate in the secondary bond or equity markets (or the tertiary derivatives market) only translates to pennies on the dollar in GDP, and the VAST MAJORITY of the recent aggregate reduction in outstanding private debt is found in the financial sector debt, of which most if not all was used for gambling in the financial casino.  This does not mean that Keen's theory is wrong, but it does suggest that unemployment may be even more sensitive to deleveraging in the household and non-financial business sectors than he concludes.
(NOTE: My previous post, which is linked to above, only discusses year-over-year change from 2008 to 2009, but Table D.3 of the Federal Reserves Flow of Funds Report shows that from Q1 '08 through Q2 '10 shows the financial sector has reduced its outstanding debt by $1.7 trillion compared to $472.8 billion by the household sector, while non-financial businesses have increased their outstanding debt by $94.2 billion.)
Keen cannot be blamed for focusing on aggregate because he started where Keynes and Minsky left off.  Keynes, however, knew better.  He understood full well that the rentier (i.e., the financial speculator) was the cause of the Great Depression, yet his General Theory does not explicitly take aim at preventing financial speculation (except to hope that implementing the general theory would lead to the euthanasia of the rentier).  Minsky, on the other hand, at least provided a complete policy prescription for curtailing financial instability caused by financial speculation.
Popular Narratives Focus on the Consumer, Not Financial Speculators

Before the Great Depression, the prevailing theory was that rising wages cause inflation and, ultimately, unemployment and deflation (the idea being that wage deflation is necessary to get back to full employment).  Although some persist in making this kind of argument implicitly with respect to the current crisis, few attempt to make the argument explicitly in face of the fact that real median U.S. wages have been largley stagnant for at least thirty years (particularly if you exclude the top decile of households). 

The new meme is that it is not the rising wages of workers that cause cause unemployment and deflation, but rising consumer debt.  For example, at the very beginning of the current financial crisis, the most popular theory was that poor people who were not credit worthy caused the crisis by failing to pay back their debts.  In spite of valiant efforts by people like Barry Ritholtz who correctly point out the many fallacies of the "CRA did it" narrative, it persists.

The most recent incarnation of "the consumer did it" story is that the average American consumer is a profligate, strung-out debt junkie that is continuing to leverage up even as the economy burns.  This is silly talk. 

First, while there is no doubt that most Americans have far too high a debt-to-income ratio in view of the uncertainty of an unstable economy, the fact is that most Americans who have a job make enough money to service the debt that they already have and are not taking on new debt. 

Second, table D.3 of the most recent Federal Flow Funds report shows that outstanding household debt has fallen every quarter since Q1 2008, and it now stands at $472 billion less than at its peak. 

Third, arguments that outstanding household debt must fall at the same rate as household net worth fail to recognize that a major decrease in home value has wiped out unrealized home equity, a major component of net worth for the bottom 90% of American households, while mortgage balances remain unchanged. 

Fourth, how exactly are the bottom 90% of American households supposed to substantially pay down their debts when the aggregate real savings rate was negative from 1998 through 2007 and the top 10% earned 35% of the wages?

Fifth, to the extent that people are defaulting on non-recourse mortgage debt, any new debt they take on for the purchase of goods will not, in real terms, increase their total debt burden, especially given that any late mortgage payments are likely to be a red flag in new credit applications. 

Finally, because financial institutions that hold household debt are in control of whether non-performing loans are, in fact, written down or marked-to-myth, and their decision is influenced by the fact that writing down household mortgage debt will also require writing down a multiple of that debt debt in the financial sector's outstanding debt, we can't really tell exactly how much household debt has effectively been reduced.

Reality: Financial Speculators Are Driving "The Consumer Dit It" Meme to Cover Their Tracks

The most recent meme is being driven by major media outlets like CNBC and the Wall Street Journal, handmaidens to debt-financed financial speculators.  You can believe them even less than orthodox economists, many of whom actually believe what they were taught in school. 

The Invisible Emperor of the Real Economy: Debt-Financed Financial Speculators

The sector of the economy that levered up at the fastest rate over the last 30 years is the financial sector.  Since 1998, financial sector debt has exceeded household debt (and non-financial business debt and government debt).  As discussed above, the sector of the economy that has deleveraged at the fastest rate since the peak of overall outstanding private debt in July 2008 has been the financial sector.  Interestingly, the outstanding debt of the financial sector actually climbed until Q1 2008.  It seems that hedge funds were levering up for fun and profit betting on the real economy.

If the financial sector levered up the fastest and has deleveraged the fastest (mostly through write-downs), doesn't that seem to compel the conclusion that the financial sector is the true cause of the current economic situation?  The financial sector does nothing productive, it merely bets on the performance of the real economy in the secondary bond and equity markets (stock and bonds purchased and sold on the secondary markets are bets, not investments), and on the performance of the American consumer in the derivatives market.  But by fueling asset bubbles to increase the number of opportunities to bet (e.g., by extending credit to high-risk individuals in order to sell derivatives based thereon), the financial sector made its bets less and less likely to pay off.  Since many of those losing bets were leveraged with debt, the financial sector's own debt is a multiple of the underlying household debt. 

Coming at it from another angle, while outstanding debt for the bottom 90% of American households is historically outrageously high compared to income, it is high because the financial sector substanitally loosened its credit standards in order to sustain the illusion of perpetually growing profits.  Clearly, we must apportion blame for the current economic situation between both profligate American households (surely a minority) and greedy financial institutions (surely the vast majority) because they were both negligent.  Just as clearly, the bulk of the blame must go to the financial institutions who took risks that endangered all of us and not the individual households who took risks that merely endangered each of them alone.