Moral Hazard, part three

Today's news tells me the U.S. will not go out of business just yet. (This will prevent me from buying some choice items at the going-out-of-business sale.) Further down the page I find reports allowing me to add two more financial institutions to the list of those still figuring out what hit them in the past. The question of what to do about the present situation remains.

(In the context of ME/CFS I want to point out that none of the current options are good from an economic standpoint. Treating this as a mental illness takes us into another morass with high costs and no good exit. Putting another million or four people on long-term disability -- with no cure in sight -- doesn't solve the problem either. The only solution that makes economic sense is prevention, plus research leading to a cure. Denial of existing liabilities is precisely what created the economic mess I'm discussing.)

Should we hunt for scapegoats to purge our frustration? Even in the financial world, I doubt this will help. We are no longer talking about a few bad apples; we are talking about a culture. Nor are we talking about a simple matter of greed, as one friend insisted. Everyone from top to bottom is busy trying to grab more than their share of a shrinking pie.

I will illustrate this by the response of another anonymous friend who heard my complete fulmination on this subject. When I got through tracing the history of economic errors from World War I to the present, and knocking down a series of arguments which he tried on me, he summed up his view by saying "there's got to be a way we can turn all your expertise into money." He couldn't even imagine unsnarling the mess, only walking away with a pot of gold. What that gold would do for his health, or even how it might feed him, should the rest of society collapse, didn't enter his mind.

The incentives which produced this behavior have accomplished exactly what we should expect. If someone can build a huge personal fortune at the price of defrauding investors, destroying a company, and spending a few years in jail, why not take a shot at it? (Remember, the generation now at the helm of many businesses was the one which idolized Jimi Hendrix and Janis Joplin. The long term was for people over 30 and thus effectively dead.) To change the behavior you need to change the incentives, and publicly hanging a few pickpockets will simply offer more opportunities for other pickpockets to work the crowd. Nobody ambitious ever expects the worst to happen to them. You have to change the incentives which govern daily behavior.

Secondly, the role of complexity and obscurity in this mess have to be seriously considered. Loud protestations that a business, or the economy, is sound have no place in economics, except as theater. If it isn't possible for independent authorities to check the numbers which tell what is going on, you should withdraw support before you find out you've been swindled. (This parallels my personal rule to get out of any game in which the dealer bristles at the suggestion I should cut cards. I pulled all my money out of General Motors stock long ago, when it became impossible to understand their annual report.) You don't want to wait until you can prove criminal wrongdoing in a court of law, by that time there may be nothing left to compensate you. Transparency is vital to staying out of court. Complexity can overwhelm rocket scientists.

Beyond pointing with pride or horror at things visible in the budget we need to tackle the question of things moved out of sight and off budgets. In the current climate, I'm very afraid a balanced budget amendment would move even more off budget and into the realm of unfunded liabilities. We don't even know the cost of various existing guarantees made at the time a complete financial meltdown was narrowly averted. In a previous cycle, several 'independent' government supported entities were created and given cute names like Fannie Mae, Freddie Mac and Sallie Mae. A surprising amount of resulting debt has been returned on our hands (though it may not appear on balance sheets).

You may not be aware that we've been through attempts to balance budgets before. The most famous stock market crash took place in October 1929. The economy continued to contract until the bank holiday of March 1933. Between these dates, a balanced budget was politically popular. Franklin Delano Roosevelt even made a speech with a promise of a balanced budget during the 1932 campaign. (At a later date, when a political adviser asked what to do about that speech, he allegedly said "try to pretend I didn't make it.")

The problem was that a contracting economy reduced federal revenues. Pulling in existing government debt when private debt was also in trouble shrank the money supply, which slowed the economy further, leading to greater reductions in revenues and increased claims on what few public benefits were available. The process had positive feedback, which led to an accelerating collapse.

Had it been possible to go back in time and rein in the expansion of debt before the crash, this might have helped to reduce the damage. Of course when lots of people were making fortunes by buying on margin any attempt to reduce the leverage in the market would have been highly unpopular, making this politically impossible to change, even if you had a time machine. So, the attempts to balance the budget took place in the deflationary cycle after the crash.

Deflation is so unfamiliar to those living today it seems like a fantasy. Isn't inflation a law of nature? Not at all.

During the contraction following the 1929 crash there was substantial deflation. We could talk about various effects of this, but I will only mention one -- existing debts became larger burdens. So, if we succeed in balancing the federal budget at the price of deflation, the $15 trillion or so U.S. debt will not increase numerically, but it will become worth more to our creditors. If you wonder if this matters, ask someone who is 'underwater' on their mortgage.

Just how big is the debt now? If I divide best estimates of current U.S. debt by current population I get about $47,000 per person. Looking at the gross domestic product, I find this is almost the same as the debt. That is, if we were all indentured to pay off the debt, we could do it in only one year -- provided we didn't spend anything during that year. A more realistic assumption would result in a longer period of indenture, possibly equal to the biblical years of servitude. (Deut. 15:12, don't take my word for it.)

Germans can tell us about the consequences of using hyperinflation to eliminate debt. That is not a good option. But, in the current environment the last thing we want to do is deflate those trillions of dollars of debt so that the dollars we must pay back are worth more. That is almost certain to happen if we impose an artificial requirement to balance budgets without correcting other systemic problems. Limiting the number of dollars of debt does not limit the real value of debt. Increasing the value of the debt without changing the numbers is a straightforward way to continue deficit spending without appearing to do so. (Is anyone prepared to tell me nobody in Washington would dream of doing anything so deceptive?)

At this point we are face to face with the question "what is this stuff called money?" That will be my next topic.


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