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How Economic Policy Errors Cause Depressions

Economics / Economic Theory Jun 30, 2010 - 05:16 AM GMT

By: Mike_Shedlock

Economics

Best Financial Markets Analysis ArticleIt is easy to pick on Paul Krugman. So easy in fact, that it is not even fair sport.

However, if you can separate the wheat from the chaff, sometimes there are nuggets of truth in what Krugman writes.


For example, please consider The Third Depression.

We are now, I fear, in the early stages of a third depression. It will probably look more like the Long Depression than the much more severe Great Depression. But the cost — to the world economy and, above all, to the millions of lives blighted by the absence of jobs — will nonetheless be immense.

And this third depression will be primarily a failure of policy.

I completely agree with those statements.

Moreover, if I take partial sentences I can find more things to agree with, such as

  • "governments are obsessing about inflation when the real threat is deflation"
  • "And who will pay the price ..."
  • "The answer is, tens of millions of unemployed workers, many of whom will go jobless for years, and some of whom will never work again."


That last bullet point was a compete sentence, the last sentence in his article. The problem is the rest of the article is loaded with Keynesian claptrap regarding policy errors.

Nonetheless, Krugman is right on the key point - policy errors cause depressions. We simply disagree as to what those policy errors are.

Krugman Also Correct About Inflation

Interestingly, most of the Austrian types mock Krugman about inflation, but on this point Krugman is essentially correct.

There is no credible inflation threat at this juncture. Hyperinflation is a complete joke. Those who get this wrong simply do not understand the role of credit in a credit-based fiat economy.

The destruction of credit and especially credit marked-to-market on the balance sheet of banks and lending institutions is immense.

By my definition we are back in deflation now. "Deflation is a net contraction of money supply and credit, with credit marked-to-market".

Price watchers are not only missing the boat, they also fail to take housing prices in their calculations.

The Price We Pay For Budgetary Murder

The reason I say Krugman is essentially correct regarding the inflation/deflation debate is that deflation is not a threat, it is a necessity as explained in The Price We Pay For Budgetary Murder.

"There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved." - Ludwig von Mises

Greenspan and Bernanke combined to stave off paying what was due in 2001-2002. The result was a massive housing bubble that ultimately collapsed.

Congress and the Fed added to the misery by wasting trillions of taxpayer dollars bailing out banks and Wall Street while leaving the private sector in shambles, and millions of homeowners debt slaves to their houses.

Each time the day of reckoning is put off, the bigger the price down the road. Thus, we should all be fearing more Keynesian and Monetarist attempts to forestall the inevitable collapse.

Attempting to stave off further debt writedowns and another recession is like attempting to stave off a hangover by drinking more whiskey.

How Policy Errors Cause Depressions

Let's start at the beginning, something Krugman fails to do.

The Greenspan Fed made countless policy errors in creating an environment of too big to fail, bailing out banks literally every time they got in trouble. The critical mistake was short-circuiting the 2001 dotcom recession.

Greenspan managed to do that by slashing interest rates, holding them too low, too long, and fueling the biggest housing and debt problems the world had ever seen.

At that point, a depression was inevitable. The only question was "how severe?"

Was Krugman a Housing Bubble Proponent?

In a 2002 New York Times editorial Krugman said "To fight this recession the Fed needs…soaring household spending to offset moribund business investment. [So] Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble."

Krugman claims "that wasn't a piece of policy advocacy, it was just economic analysis."

For links and further discussion please see Krugman's Intellectual Waterloo

Policy Error #2

No policy decision is so bad that it cannot be made worse. Bernanke failed to see Greenspan's error and could not even see a housing bubble that was obvious to anyone with an ounce of common sense.

When the bubble finally did burst the Fed in cooperation with Congress and the treasury department bailed out the banks, the bondholders, and Wall Street at the expense of taxpayers. That was a second critical mistake, guaranteeing the relapse we see now.

Banks still are capital impaired, banks still are not lending, consumers are still deep in debt and the Fed and Congress did not cure any structural problems (including Fannie Mae and Freddie Mac) with their bailouts.

The waste of bailout capital will without a doubt affect "tens of millions of unemployed workers, many of whom will go jobless for years, and some of whom will never work again" just as Krugman says.

Unfortunately, Krugman has the wrong reason. The policy error is not as Krugman thinks (failure to throw more money at the problem), but rather throwing any money at the problem.

Bondholders should have taken their punishment, not taxpayers. Instead, taxpayers were forced to pay for the bailout via higher taxes from the Obama administration.

European Policy Errors

In Europe, the ECB made similar policy errors in attempting to bail out French and German banks in deep slop over poor loans to PIIGS, primarily Greece, Portugal, and Spain.

The correct policy decision in Europe (assuming the foolish loans were already made) was to restructure the bad debts at a pace that could actually be paid back. Instead the ECB insists that Greece, Spain, and Portugal pay back those loans in full, something that I guarantee you will not happen.

Here is a simple point-by-point analysis that shows how that policy error will effect on the entire global economy.

How Policy Errors Cascade

  • As long as the ECB's "extend and pretend" policy is in play, Greece, Spain, and Portugal will remain wrecked while burdened by loans they will eventually default on anyway.
  • In that timeframe, European growth will be anemic at best. Indeed, it is far more likely that Europe will slide back into a deep recession than simply sputter along.
  • As long as European growth is weak, China will be weak because Europe is China's largest trading partner.
  • If China's exports decline, China will need fewer imports from Australia and Canada.
  • If China and Europe are weak, there will not be tremendous demand for US exports.
  • Global job growth will remain weak.
  • Fiscal stimulus measures will fail.
  • Earnings estimates will surprise to the downside and the global equity markets will be extremely vulnerable to further losses.
  • Further equity losses in conjunction with absurd pension benefit assumptions will bankrupt many city, state, and municipal pension funds.

This is the insanity of "extend and pretend" measures not only in Europe but in the US as well.

US Public Sector Policy Errors

Obama and the Democrats are doing their best to keep public sector jobs alive. This is a poor policy decision because Firing Public Union Workers Creates Jobs.

Moreover, wasting hundreds of billions of dollars on military spending is another piss poor policy decision. We should declare victory in the war in Afghanistan and pull our troops out, not just in Afghanistan but globally.

Instead of wasting $1 trillion attempting to be the world's policeman, how about cutting military spending by two-thirds, lowering income taxes, and cutting corporate income taxes to zero on profits held in the US?

Instead Obama is raising taxes, placating public unions, and wasting money warmongering.

Policy Errors in Europe

Europe is far ahead of the US in wanting to do something about public sector unions as noted in UK Prime Minister Warns "Years of pain ahead, No Trampoline Recovery"; Time for U.S. Public Unions to Share the Pain Too.

Also see Whistleblower's Account of UK Public Sector Work.

However, the UK is looking to raise the VAT. Increasing taxes is the last thing a recovery needs.

Every one of those bad policy decisions affects the global economy.

The implications of this set of global policy errors is extremely negative, so much so that I have to agree with Krugman "We are now, I fear, in the early stages of a third depression".

The reason however, is absurd measures of Keyensian and Monetarist stimulus, war-mongering, and other Congressional nonsense, not the failure to do more. Thus, Krugman is off by 180 degrees as to why and what to do about it, even if some of his statements in isolation appear to make sense.

By Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com

Click Here To Scroll Thru My Recent Post List

Mike Shedlock / Mish is a registered investment advisor representative for SitkaPacific Capital Management . Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction.

Visit Sitka Pacific's Account Management Page to learn more about wealth management and capital preservation strategies of Sitka Pacific.

I do weekly podcasts every Thursday on HoweStreet and a brief 7 minute segment on Saturday on CKNW AM 980 in Vancouver.

When not writing about stocks or the economy I spends a great deal of time on photography and in the garden. I have over 80 magazine and book cover credits. Some of my Wisconsin and gardening images can be seen at MichaelShedlock.com .

© 2010 Mike Shedlock, All Rights Reserved.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Comments

Nadeem_Walayat
06 Jul 10, 01:09
Still Deflation ?

Mish writes:

"By my definition we are back in deflation now. "Deflation is a net contraction of money supply and credit, with credit marked-to-market"."

Deflation is actually -

In economics, deflation is a decrease in the general price level of goods and services.[1] Deflation occurs when the annual inflation rate falls below zero percent (a negative inflation rate), resulting in an increase in the real value of money – allowing one to buy more goods with the same amount of money.

http://en.wikipedia.org/wiki/Deflation

U.S. CPI is 2%, expected to fall to 1% by end of 2010 - Still Inflation.


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