28 Sep 2008

Bruce Bartlett: Another Fair-Weather Friend of the Free Market, & Commentary on Capital Consumption

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Well shoot, just when I thought we had this all locked up from a disinterested academic viewpoint, Bruce Bartlett comes along and endorses the Paulson Plan. He starts out by explaining the fractional reserve system. It doesn’t appear that Bartlett has even considered whether fractional reserve banking is a good idea; he just takes it as a given, to explain why banks are more fragile than other industries and so need a bailout.

But then he gives us these hysterical warnings:

There are, of course, policies in place today that didn’t exist in 1929 that make another Great Depression unlikely. (The most important is federal deposit insurance for the vast bulk of deposits.) But there is still a great danger that, if the financial sector becomes overloaded with assets falling in value, it could lead to a long period of economic stagnation, such as that suffered by Japan in the 1990s.

One reason for this is that Federal Reserve policy becomes impotent when the financial system simply can’t distribute changes in the money supply throughout the economy.

We’re seeing evidence of this already, as interest rates on Treasury securities fall to very low levels. When this happens, we have what economists call a “liquidity trap” – and it means that the Fed is incapable of stopping a deflation once it gets started.

Bottom line: We’re closer to the precipice than Congress or most of the public understands. Our entire economic system really is at stake – and those treating the bailout plan as just another government spending program are seriously wrong.

Failure of this plan risks another Great Depression. Really.

You can see the fear in Treasury Secretary Henry Paulson’s eyes and in those of Federal Reserve Chairman Ben Bernanke. But they dare not say how critical the situation is – lest it shake confidence and make matters worse.

C’mon Bruce, the reason the Great Depression lasted a decade, and the reason Japan’s economy was in the toilet for so many years, was that the American and Japanese governments prevented adjustments in the structure of production.

I really don’t understand how these people think the world works. In U.S. history up through 1945, all but one of the economic downturns was over within two years. (I am pretty sure that’s right, though I might be forgetting an episode.) Yet the Great Depression arguably lasted over 10 years. At the same time, we all know without doubt that FDR’s New Deal was the most ambitious attempt ever by a US government to wage war against a bad economy.

So I want to conclude that the Great Depression lasted so long because of the New Deal. This fits perfectly with economic theory; if the government and unions prop up wage rates during a deflation, you get massive unemployment. Simple stuff.

Yet those who want to argue that there are just random chaotic forces that suddenly push fragile free markets into sluggishness, and that a strong central government response is needed to correct things: Are you saying that if FDR/Fed had done nothing, then the Great Depression would have lasted, say, 20 years–thus proving that FDR saved the country? And so that means you think these ticking time bombs latent in advanced capitalist economies, were just popping out in two-year bursts throughout US history, and then all of a sudden in 1929 there was a 20-year burst of bad vibes? And now, 79 years later, we just got hit with another random burst of super bad financial vibes?

I am not trying to be flippant. The people warning of a credit collapse have a point: It really would be awful for a while if the banking system (with check clearinghouses etc.) actually shut down.

But no matter how bad it was, if the politicians would for once just stand back and watch entrepreneurs make small improvements here and there on the edges, after 12 months things would be back on solid footing. The recession would be over, workers would be in the appropriate jobs, and growth could resume.

But instead of that, the government is going to do everything in its power to cajole Americans to continue consuming more than they produce. Financially, this of course translates into more debt held by Americans (whether privately or from government IOUs). Physically, it will manifest itself in a shrinking of the capital structure. Not enough real resources each year will go into reproducing the machines and other equipment being worn out over the course of the year.

Because resource flows can be rearranged, for a while this capital consumption need not restrict total consumption. The same amount of cereal boxes and F-150s can crank out of US factories every month, for a while. But “higher up” in the production structure, the necessary replacement investment is not occurring. So at some point, even if they are willing to say, “To heck with the future!” it will be technologically impossible to maintain the current level of output of consumer goods.

On top of the politicians’ efforts to prevent Americans from rationally responding, and curtailing their consumption during these hard times, there is now another problem: The politicians are directly interfering with the financial markets. Thus the market prices that guide entrepreneurs are going to be a lot fuzzier; their information content will be lower, if you will.

We’re heading for another Great Depression, all right, but it’s not because of “the liquidity trap.” No, it will be due to the “Obamanomics Trap” or the “Palinomics Trap.”

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