A Close Shave with Occam’s Razor

June 30th, 2014 at 9:18 am

Dean Baker goes on a vicious—even for him!—tear in response to Robert Samuelson’s column this morning on the state of economics knowledge about the business cycle.  Dean’s take down is definitely worth a read, as I too have been struck by the increasingly complex explanations offered for a sequence of economic events that seems fairly straightforward, though as Dean stresses, was broadly missed (though not by him).

Dean takes you through the details, but they’re well known to my readers as well: housing bubble inflates, enriching credit providers/intermediaries and ignored by financial regulators, bubble bursts, huge negative wealth effect and negative shock to credit system, deleveraging cycle exacerbated by lack of debt forgiveness (policy mistake #1), fiscal response was and is insufficient (policy mistake #2).

Am I shaving too close with Occam’s Razor?  Not that I can see, but feel free to add complexity if it is warranted.  Dean argues that those who missed all of the above are compelled to weave a complex web of events to protect their reps.  Perhaps so.  At any rate, like they say, “make your explanations as simple as possible but no simpler.”

There are two closely related pieces of all this that I’d like to pull out, because unlike the accountability question of who missed the bubble and why (not that this is unimportant), they’re forward looking.  Both relate to not learning the wrong lessons from the Great Recession and weak recovery.

First, there’s an idea in the Samuelson piece that I hear a lot, and its sequencing goes like this: each cycle in recent decades involves a destructive bubble.  Said bubbles are in no small part the fault of the Federal Reserve, i.e., the bubbles are the unintended consequence of their macro-management policy: by holding down interest rates to stimulate more demand, they’re inflating asset bubbles.

This line of thinking, of course, embeds an implicit up-weighting of the Fed’s anti-inflation mandate and down-weighting of their full employment mandate.  As you can imagine, that makes me unhappy, and we don’t want that.

One reason it is wrong is it ignores the critical role of financial oversight, both by the Fed and other banking regulators.  If you’re worried about your weight, you could stop eating, or you could regulate your intake to healthy foods in moderate portions.  The former will kill you, the latter will make you healthy.  The Fed of course must be able to practice macro-management through interest rate policy.  Ample, adequate financial market oversight is an essential complement to those activities.

Second, expansionary fiscal policy is a highly effective response to temporary demand contractions but you’ve got to apply it until it’s no longer needed.  Again, this is simple arithmetic.  GDP is nothing more than (C)onsumption, (I)nvestment, (G)overnment spending, and net exports.  In expansions, the private sector taps demand leading to more C, which signals investors to engage in more I and a virtuous cycle is underway (our persistent trade deficits are a big problem in this story but put them aside for now).  In recessions, C&I are temporarily missing in action, and G must step in.

And, in fact, G did so with the Recovery Act and subsequent stimulus measures as well, but the pivot to deficit reduction came too soon.  Just last year fiscal drag took a huge 1.5 percentage point bite out of GDP—by Okun’s Law, that’s 75 basis points added to the unemployment rate.  (Baker: “It’s sort of like the fire department that rushes to the burning school building and watches in horror as it goes up in flames because they had forgotten to turn on the fire hydrant.”)

So let’s be careful not to learn the wrong lesson here either.

I see no obvious reason to “call in rewrite” when it comes to our basic understanding of recent economic history.  Large, persistent bubbles do tremendous damage when they burst so financial oversight must be vigilant in spotting and deflating them.  Both fiscal and monetary policies are effective, but the former must stay “on” until it’s no longer needed (and then, to avoid longer-term deficits, it must come “off”) and the latter must be complemented by financial oversight to avoid excessive asset inflation.

If you want to wind yourself up in knots of complexity, be my guest.  But in the interest of the greater good, unless you’re sure it’s needed, please keep it to yourself.

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7 comments in reply to "A Close Shave with Occam’s Razor"

  1. Tyler says:

    Here’s what I get: the Republicans are dedicated to President Obama’s failure. Therefore, they’re not going to support anything he proposes which would improve the lives of Americans.

    Here’s what I don’t get: why doesn’t President Obama try for a tax cut for the middle class? Yes, the Republicans would want to oppose it, but they wouldn’t be able to because everyone knows they’re the party who loves tax cuts. Even if they were dumb enough to oppose it, President Obama could use it against them as we approach the midterms.

    Am I just engaging in wishful thinking here?

    • Chris Herbert says:

      Middle class tax cut would be good, but it should be matched with a tax hike on the super wealthy, or at minimum close loopholes that the wealthy use to defer taxes. The Republicans also want to reduce deficits, remember. This puts them in a huge bind. They cannot raise taxes on the rich, but they also can’t oppose something that’s revenue neutral either. Nothing would pass, of course. But it would reduce Republican vote totals, which should be job number one.

      • Tyler says:

        Republicans claim they want to reduce the federal budget deficit, but that’s just a lie. They like a large federal budget deficit because then they can say, “The federal government is spending too much, as evidenced by the large federal budget deficit!”

  2. John Daschbach says:

    One real question which seems to go unanswered in this discussion is does the Fed really have much impact on interest rates. One camp seems to think the Fed controls interest rates and often sets them too low. But the mechanism of lending makes this connection questionable. Banks borrow from each other at the margins to satisfy transaction settlement and reserve requirements. Borrowing at the discount window (directly from the Fed) is so small as to be meaningless. We should ask, what would inter-bank borrowing rates be without the Fed setting a target Fed Funds Rate (and engaging in OMO’s)? It is almost certainly lower than it is with the Fed involved or otherwise we would expect regular substantial borrowing at the discount window. It’s important to understand that the Fed Funds market is really only at the margins, borrowing in the Fed Funds market only takes place when inter bank fluctuations lead to an imbalance of assets and liabilities that place a bank outside it’s reserve and transaction clearing limits. In aggregate for banks there is zero net borrowing in the Fed Funds market. That’s just simple math. Loans create deposits and it’s only the fluctuations in where loans and deposits end up that lead to rebalancing through the Fed Funds market. An easy way to understand this is think of a system where there is only a single bank. Then the Fed has zero impact through it’s traditional tools to lower interest rates.

    I think we have developed a misunderstanding of how impactful monetary policy is (or is not). The growth rate of consumer borrowing has mostly increased during periods of Fed tightening and dropped only when unemployment spikes during a recession. When the correlation is very strong with unemployment and weak with Fed policy the Occam’s razor argument should not be based upon Fed monetary policy. Damaging bubbles can probably be partially ameliorated through legal and regulatory means. If I’m correct that the Fed has some ability to raise interest rates but little ability to lower them (in our structure) then it seems that those who argue against the Fed desire a system with far more damaging bubbles.

  3. James Edwards says:

    There’s an important aspect of the housing crash that is often overlooked. Imagine I buy a house and put $100k down and borrow $100k. I’m very responsible. The housing crash comes and whacks $50k off my home’s value. Who takes the whack? Me, 100%. That severely cuts into my ability to spend if I was planning on my home as part of my retirement. I have to make that up. So, even responsible homeowners took a beating in the crash while banks were lavishly bailed out.

  4. Mark Jamison says:

    Dean (and you) have hit the interfibrous friction fastener on the cranial osteostructure. Liars loans and the misrepresentation of securitized paper were not failures of Fed interest rate management. They were failures of the Fed’s oversight responsibilities.
    The Right has strained at a gnat to make the financial crisis a government failure but in the end it was a market failure due to deregulation. Markets are not natural occurrences, they succeed or fail based on the parameters that define them.

    Off topic – over at Angry Bear Robert Waldmann has a nice discussion about the legal constructions of corporations and unions (relating to yesterday’s two SCOTUS decisions). Any thoughts?

  5. mulp says:

    Since 1980, the public policy advocacy and action has been:
    tax cut and deregulate

    Things get worse, blame too high taxes and too much regulation
    tax cut and deregulate

    Things get worse, blame too high taxes and too much regulation
    tax cut and deregulate

    Things get worse, blame too high taxes and too much regulation
    tax cut and deregulate

    Things get worse, blame too high taxes and too much regulation
    tax cut and deregulate

    Occums Razor would suggest the reasons things have gotten worse for more than half the people is that tax cuts and deregulation make things worse for the majority of the people.

    After all, the best half century was from 1930 ro 1980 when it was tax and spend, tax and spend, tax and spend.

    After all, conservatives tell us the half century of Democratic control from 1930 to 1980 were totally tax and spend big government, and then they promise to make us rich when just getting back to middle class would make most people happy.