Shiller: Against Market Fundamentalism

Far too often, debates devolve into black-and-white affairs, with strawmen on both sides taking a pummeling. Robert Shiller's latest piece in the Wall Street Journal takes on this type of Manichean thinking, as he adopts the Herculean task of convincing economic conservatives that not all financial regulation is bad. From the WSJ:

The principal long-term result of the current financial crisis should be improved financial regulation. After the immediate crisis is over, we need to restructure our fragmented system. This process will take years to complete since, if properly done, it should get at the heart of the regulatory structure.

This is not as radical as it sounds, for while many observers equate U.S.-style capitalism with unconstrained free markets, the story is more complicated. Americans have long understood that for the economy to work well, government must play an important supporting role. They've also long understood the important role that self-regulatory organizations (SROs), such as trade associations and exchanges, play in cooperation with government regulation.

An understanding of animal spirits -- the human psychology and culture at the heart of economic activity -- confirms the need for restoring the role of regulators as guiding hands in a healthy, productive free-enterprise system. History -- including recent history -- shows that without regulation, animal spirits will drive economic activity to extremes....

Such a world of animal spirits justifies the economic intervention of government. Its role is not to harness animal spirits but really to set them free, to allow them to be maximally creative. A brilliant player wants a referee, for only when the game has appropriate rules can he really show his talents. While the sports of baseball and football haven't changed much in the last century, the economy has -- and American financial regulation hasn't had an overhaul in 70 years. The challenge for the Obama administration, along with the U.S. Congress and our SROs, is to invent a new and better American version of the capitalist game.

You might think this is an uncontroversial point. Unfortunately, it is not. What was that about Dark Ages again?

Can the Government Stimulate the Economy?

If two conservative economists discussed whether fiscal stimulus can ever work, and one exposed the debate as irrelevant to our current crisis, would the other even notice?

The answer seems to be no. Russell Roberts gives what he apparently believes is a deep and philosophical critique of Keynsian spending, arguing that government spending (G) effects consumption (C) and investment (I), such that an increase in G will lead to a decrease in C and I; they are more or less zero sum. Robert's argument rests on the assumption that an increase in G necessitates higher taxes, which individuals and businesses will factor into their spending and investment decisions, offsetting the effect of any higher government spending. This is recycled Treasury view masquerading as insight.

But then Arnold Kling exposes one of the fundamental flaws of the Treasury view: it assumes something close to full employment. When the economy is near full capacity, government deficits more or less would crowd out private investment. But when resources are being unemployed, this does not apply. And today we certainly have idles resources, between private capital sitting on the sidelines, pouring into short-term Treasuries, and unemployment itself rising above the equilibrium level.

Roberts seems oblivious to the implications of Kling's argument. The Dark Ages are quite dark, indeed.

Robert Barro: Stock Market Crashes Are Bad

So get this: stock market crashes are bad. Don't believe me? Well don't take my word for it - listen to Harvard professor Robert Barro, who recently studied the correlation between stock market crashes and depressions (defined as at least a 10% drop in GDP or consumption). Barro's conclusion:

In the end, we learned two things. Periods without stock-market crashes are very safe, in the sense that depressions are extremely unlikely. However, periods experiencing stock-market crashes, such as 2008-09 in U.S., represent a serious threat.

I'm glad Robert Barro is here to tell us these things. Really, I am. But here's a tip: his study might actually be meaningful if he included debt levels as a variable. Debt deflation - a d-process - is the real culprit when it comes to depressions. As Irving Fisher described, when assets used as collateral for loans undergo price deflation, economies can fall into a downward spiral of deleveraging, leading to further falls in asset prices, and then even more deleveraging, as the two processes feed on each other in a negative feedback loop. I suspect if Barro redid his study and considered debt levels as well that the odds of today's crisis spiraling down into a depression would be significantly higher than the 20% figure he gave. I doubt he would compare our current situation to the crashes in 1974 and 2001. What does it say about the state of academic economics that "stock market crashes are bad" passes for insight from a professor at our nation's top university? Dark Ages, indeed.