Sunday, November 2, 2008

Missing the Fundamentals

We are headed in the wrong direction. The bailout is a “fix” for our financial troubles in the same way that taking more drugs is a “fix” for an addict’s addiction. Injecting more fiat money into our economic blood stream may give us a temporary sense of relief, but only at the price of a more severe withdrawal reaction in the future.

Analysts have offered a plethora of causes for the current down turn: greedy bankers, the unregulated shadow market, securitization and complex derivatives, predatory lenders, deadbeat borrowers, housing speculators, Fannie and Freddie, the CRA and ACORN, adjustable mortgage rates, low interest rates, preferential tax treatment of mortgage interest, and so on. The large number of “explanations” in and of itself should serve as a signal that the fundamentals are not understood. Clearly, all those listed contributed. Underlying these factors, isn't there a more fundamental primary driver?

Examined more closely, you will see that most of these “causes” simply tell us why this boom-and-bust is in the housing market. They don’t really address why the boom-bubble-bust occurred in the first place. Eight years ago, it was the dot-com bubble. And before that, there was the Asian financial crisis. And what about the recession back in the early 1980’s? Might there be something which could explain the phenomena of bubbles and the business cycle in general? And if we "fix" the housing bubble bust now without identifying the primary cause, what's to prevent another bubble in some other sector in the future?

The best answers look at fundamental principles. We see this in the scientific process which takes an immense number of concrete specifics and integrates them into a law or theory. Like Einstein’s E=mc2. Or the ideal gas law, PV=nRT. Or Dalton’s atomic theory, or Bassi’s germ theory. Each of these took a set of diverse, previously unexplained occurrences and discovered the underlying principle which connected and explained them all. The new, deeper understanding then triggered an explosion of progress, both in further theoretical research and in the efficacy of its application.

To find long-term efficacious solutions to extreme financial volatility, we must understand the fundamental economic principles which are operating. Since the early 1900’s, our banking, financial and monetary policies have been heavily influenced by two major schools of thought: Keynesian economics and monetarism. These theories are flawed. The policies they justified have failed, along with the banks and other businesses which were required to try and exist within their flawed system.

Two key economic principles must be understood in order to untangle the Gordian knot of today’s financial crisis. The first is the difference between commodity and fiat money and the effect they each have on the market. The second is the instability of a mixed economy.

In future posts I will address the role that each of these has played leading up to today’s down turn, and why we won’t have a permanent turn around until we return to a true free market.



Anonymous said...

The fundamental driver is the same as that which drove the South Seas Company and Holland Tulip bubbles several centuries ago. Greed. Plain and simple. All the causes you list are either the actors who participated in the bubble or the tools they used. The driver is greed. And a lack of responsibility and accountability. You mentioned complex derivatives in passing, alluding to credit default swaps. These are a key ingredient in the precipitation and breadth of the crisis and if you thoroughly investigate their characteristics and role in the crisis you may not reach the conclusion you stated without substantiation.
Bubbles are simply irrational exacerbations of the business cycle. They are the result of greed and 'pile on' mentality on the upside, and fear and stampede mentality on the downside. And they occur in everything from real estate to darling stocks to Beanie Babies.
The Asian financial crisis was precipitated by forced free market economics imposed by the WTA and the World Bank and unsustainable exchange rates. The dot com bubble was the result of unrealistic assumptions about the impact of the Internet on economics and the resulting abandonment of rational valuations. This crisis is very similar to the bubbles cited in the first paragraph.
Your analogy to physical science belies a background in the sciences and maybe a bit of discomfort with uncertainty. Economics will never yield to simple laws because test tube experiments are not possible. Therefore single variables can’t be isolated experimentally. Game theory probably offers the best opportunity to understand why bubbles occur because it allows inclusion of the effects of greed and fear, as well as rational thought, which are the underlying factors in market volatility. However, bear in mind that groups of Nobel Prize winners and other world renown financial wizards (e.g. Long-Term Capital Management) have been burnt badly using such theories because while probable actions of players can be rationalized there is always considerable uncertainty due to limitations of models and incomplete information about motives (other than greed), strategies, and capabilities of all players in the market.
Your thoughts and proposed solution are incongruous. Stating that a ‘return to a true free market ‘ would solve the problem, before defining the problem adequately, puts the cart before the horse. A few questions that come to mind are (1) when was the last time we had an unregulated free market? (2) What was it like before Keynesian and monetarist economics and why did they come into being? (3) What are the characteristics of modern examples of unregulated free market s and what are the social implications? (4) Were there free-market aspects of the current crisis? What were they? What role did they play in the crisis? (5) How could we minimize the possibility that crises like this one won’t occur in the future? (5) Given that you advocate for ‘true free markets,’ how does free market capitalism and its attendant distribution of wealth and power compare with the tenets upon which the Framers crafted the Constitution and the way they designed our government?

HaynesBE said...

To anonymous:

Wow! Thanks for your comments!
It will take a while to give them adequate consideration, but I do appreciate them. Are you the same anonymous as from my most recent post?
Your questions are great....but seem to be a request for a book rather than a blog post. However, I am working on an attempt to address some of the issues you raise: the history of regulation in the market, esp. regulation of banks and money; the role of Keynes' ideas in leading to ever greater statist intervention; using historical experience to illustrate that the freer the market, the greater the rise in prosperity for everyone.

I am very aware that my philosophy of science is out of synch with how it is taught today, especially on the modern split between inductive and deductive reasoning as applied to science, as well as the prevalent acceptance of a false dichotomy between the empirical and the theoretical. Disagreement with standard approaches and conclusions is not the same as a lack of background. That goes for science as well as for economics.

If you have a place where you defend your interpretations of current events, I would appreciate the opportunity to read them.

Thanks again.

HaynesBE said...

One other thing: on credit default swaps and other complex derivatives. Someone else pointed me in that direction to better understand their contribution to this mess. From what I can gather so far, and I still need to understand this issue better, they certainly contributed inflating and destabilizing the bubble. What I am unconvinced of thus far is that they are a fundamental cause of the current situation, rather than simply one of the many deleterious effects.

Clearly, understanding the cause of the business cycle is crucial here.