Sunday, January 18, 2009

How To Fix The Economy

I like to fix things. This should be no surprise, as I am an engineer. Of course some engineers prefer to only build new things, and do not like to fix existing things, but not me. Sometimes this works against me. Whenever I encounter a problem, my first reaction is to try to figure out how to fix it. Sometimes that is not appropriate, and sometimes the problem just cannot be fixed. That is a tough thing to admit: that a problem cannot be solved. Even tougher is to spot such problems without first repeatedly failing to solve it.

What does this have to do with the economy? The economy is a problem that cannot be fixed. There is no one thing or series of things that can fix this problem. Giving money to banks has already proved to be ineffective, as has eliminating interest rates. Now some folks want to take even more drastic measures. But it is not going to work.

We like to think that we are so smart that we can understand anything, and thus solve any problem. But we are not that smart, not even close. Some things are too complex and macroeconomics are too complex. If it was possible to understand macroeconomics enough to control it, then the Soviet Union would still be running along smoothly. The Great Depression would have only lasted a few years. You get the idea.

Not convinced? Look at the causes of the Great Depression. The Fed was established the Federal Reserve Act in 1913. It really got to work after the end of World War I. Starting in 1921, The Fed used a variety of "levers" to increase the total money supply by more than 60%. The Fed made the "boom" part of the business cycle extra "boomier", but the result was an even bigger bust. Banks were incentivized to make malinvestments. When they could not cover the malinvestments that failed, a "run on banks" ensued.

Does this sound familiar? The Fed did the exact same thing in this past decade. There was no "run on banks" this time because of FDIC (more on that in a minute.) Instead there was a run on other investment instruments, and the result was equivalent : insolvent financial institutes. Only things are worse this time. Why? FDIC.

Smart people back in the 40's thought that the Depression was caused by the run on banks, not recognizing that as symptom of the sickness, not the cause. So they tried to prevent bank runs by enacting FDIC. If the government insures your deposit, then you should not freak out and pull your money out of the bank, right? Of course this creates a moral hazard because it removes some of the risk of investment. So what do we do? Regulate.

What happens? The regulation becomes dated as new types of investments are invented that are not subject to the regulation. One could argue that the reason for these new investment was to avoid paying the tax of regulation and thus give a higher return. However, the moral hazard is even worse. Even though these instruments are not insured by the government, the precedence has been set. Investment banks know that the risk will be absorbed by the government. Meanwhile the Fed once again inflates the money supply, as the government needs a big "boom" to help pay for wars, and like clockwork, we get another dramatic bust.

Do we admit that FDIC didn't work? Nope. Instead we think that the problem was that we didn't regulate those pesky new investment instruments! This is coming from a Nobel Prize winner, so it has to be The Truth, right? While the specter of government force looms as the ultimate "fix."

So am I just proposing that we roll over and do nothing? Well ideally this would be an opportunity to do things that are generally good for the economy: reduce taxes, reduce regulation, increase trade. However when most of the experts propose well-meaning solutions that would often do just the opposite, maybe the status quo is all we can hope for?

Does this mean that banks fail, businesses fail, and people lose their jobs? Yes, it does. Everyone wishes there was some magic button to push that would prevent these awful things from happening, but there is not. None of the dramatic (and unconstitutional) actions of The New Deal succeeded in fixing that mess. Maybe they prevented things from getting worse in some cases, but they also drastically prolonged The Depression and laid some of the seeds for today's problems.

Of course FDR was re-elected three times and that is all that matters to politicians. So get ready for a lot of fixes, and get ready for a long depression. Let's just hope that this economics meltdown doesn't end like the last one.


GFreak said...

I appreciate your observation of the unconstitutionality of the New Deal and similar presidential-spending plans.
For me the worst part of the Bush era is not the Iraq War, is not the dead economy, and is not just him being stupid. It is the piece by piece dismantling of Constitutional Law.
I understand that you are not necessarily a "conservative", but I've really come to love the opinions written by Justice Clarence Thomas.

On a side note (and this is not directed at you, Mike)-- I usually hate people discussing "Constitutional Rights". Those people need to read the Constitution, understanding that it was written to limit government, not grant rights. We have rights (granted by our Creator, the Universe, or whatever you believe); the Constitution was written to prevent the government from taking those rights from you.

Morgan said...

Wow, Michael. Very insightful, and clearly stated. I would also tend to agree, that a hands off approach would be better than screwing this train wreck up more. And since I believe that our government was the greatest contributor to this carnage in the first place, I would support it being even less “involved” than it is now.