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Have We Learned Anything Yet?

by: James Picerno October 07, 2008    
James Picerno

James Picerno

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The rolling crisis that has become the daily routine of late has no obvious and immediate solution, but at least we can be clear about how we arrived in this thankless position. And maybe, just maybe, we can learn a thing or two about policymaking for the years ahead. It won't be easy, but progress never is, especially in the dismal science.

Facing up to reality offers no silver bullet answers, but ignorance will only aggravate our troubles in the future. With that, let's acknowledge that the current mess is the consequence of years, perhaps decades of mistakes and short-sighted policies. The list is long, and the details complex. Volumes will be written about how policy makers stumbled. For now, we'll revisit one issue that this observer believes has been central, though hardly alone in the buildup to the problems that afflict us.

Arguably one of the bigger missteps flows from the idea that the economy can be reengineered and manipulated so that recessions are a thing of the past. For quite a while it's been tempting to think that the Federal Reserve and its counterparts around the world figured out how to smooth out the rough bumps in the business cycle. Viewed through the perspective of history, the Great Moderation looked like the answer to every central banker's prayers. The goal certainly was a populist winner: recessions that were less frequent, less painful and perhaps even a vestige of a bygone era. For a while, the impossible seemed possible. A look over the history of business cycles certainly gives that impression via fewer, less painful downturns. That appeared to be the new world order, and the assumption was that the retooled cycle rules could go on forever. The tech bubble burst early of 2000-2002 was a warning shot, but most chose to ignore it, in part because for all the pain of that episode, consumer spending never really suffered, thanks to Greenspan's Fed.

But the kinder, gentler cycle was a myth. Rather than dispensing economic pain to the dustbin of history, it was only pushed into the future. The Federal Reserve has spared no expense over the past generation in pre-empting the first sign of trouble by cutting interest rates and creating liquidity first, and asking questions later. Never mind that the policy promoted debt and greater risk taking. It seemed to work, with no apparent price tag.

Politically, this has been popular, as of course it would be. There is no constituency for recession; there is no lobbying group calling for the cleansing action that comes from corrections. But while no one wants economic pain, inevitably it comes. Preventing the beast from emerging, or moving heaven and earth to moderate it, eventually creates bigger trouble down the line.

The reason is partly tied to the fact that humans make mistakes. As a result, money is lost, companies close and people lose their jobs. That can't be legislated out of existence any more than gravity can be banished from the Earth. Fortunately, loss is the exception, which is why the world economy tends to grow over time. The net change in GDP is positive in the U.S., and for the planet generally in the long run. That's a direct function of the innovation and productivity that arises from Mother Earth's workforce. But for all of that, we're not perfect. Not every investment is profitable; not every company endures. Capital destruction isn't pretty, but it's familiar and it's inevitable. Luckily, it's relatively rare. But rare isn't nonexistent.

As such, neither is financial pain. Shareholders lose their investment, perhaps all of it; workers lose their jobs; etc. That's a problem if your investment was defined exclusively in shares of a failed company. Of course, diversification easily solves that problem. As for unemployed workers, well, that's more complicated, but there are two main issues to consider. One, jobless benefits in the short term help smooth over the rough edges of cycles. Two, promoting and nurturing innovation and productivity in the economy improves the odds that eventually the unemployed will find new opportunities. That's not a dream; it's reality, which is why the blacksmithing industry is gone and software engineering is prospering.

Nonetheless, there's a fine line between promoting economic growth and preventing recessions. Yes, we want lots of the former, but going too far in search of the latter may at some point create more problems than it solves. The rubber band only stretches so far, much as we'd like to think otherwise.

To be fair, it's not obvious where healthy central banking stops and ill-advised cycle engineering begins. But there is a tipping point, and simply recognizing its existence is the first step on a thousand-mile economic journey. And for all our criticism of the Fed, it should be recognized that central banking in this country, and in many countries around the world, has improved considerably over time. But what we don't know about intelligent central banking and how it interacts with business cycles still exceeds our collective wisdom. Progress arrives, but it's painful. As recently as the 1970s, remember, the economic chieftains of the Fed believed that economic growth flows directly from printing money. Learning that lesson wasn't easy, but it was necessary.

What, then, are the lessons in the here and now about the limits of trying to preempt, forestall and otherwise sidestep the natural course of business cycles? No, we don't have definitive answers or detailed policy prescriptions, nor does any one else, at least not yet. Trial and error is still the only game in town, and that's a tough way to gain insight. We can do some of it, much of it on paper, but some of the answers will only come from the field.

Meantime, this much is clear: The previous 20 years of sparing no effort to avert cyclical pain, with no thought as to the outcome, has a price. We'd all like to think that the tactical plan of injecting morphine into the economy to keep everyone feeling happy incurs no pain. But that's a fantasy. Moral hazard eventually has real world consequences. Inhibiting macro corrections in the short run isn't a long-term solution, at least in terms of pursuing the goal without recognizing its limitations.

The hope that consumer spending would always grow, via debt or other means; the desire to see home prices continually rise; the expectation that stock prices will never suffer prolonged corrections; etc., etc., etc., has come to an end. But the game couldn't roll on indefinitely. Perhaps our biggest problem was simply thinking otherwise.

The great challenge for the years ahead is finding a reasonable balance between promoting growth and prosperity while allowing a prudent degree of excess trimming. This is a political question as much as it is an economic one. But answer it we must, and that starts with recognizing what's gone wrong.

In some ways, we've come full circle since the creation of the Fed. Recall that in the early 1930s, the policymaking bias was standing back and letting the market heal itself. (Actually, the Fed negatively intervened in the early '30s with monetary tightening, but that's another story). By contrast, in the last 20-plus years, the Fed has been aggressively intervening in an effort to manage the business cycle in an effort to keep everyone happy now and forever. Is there a third way?

No, we're not saying that recessions should be left to run their course. We've learned too much over the last 80 years to go back to that. But we must also recognize the other extreme, and its subtle but ultimately painful consequences that pop up eventually.

As we ponder the question how to proceed, there's no doubt that the business cycle is having its way with us now, reminding us that we weren't as clever as we thought we were. The good news: The long-averted cleansing will one day give way to a stronger, more robust cycle of growth. But first we have to survive the correction.

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This article has 35 comments:

  •  
    Oct 07 01:10 PM
    There is no lesson here; nobody will learn anything! The FED will regain control over the financial system and the economy and in a few years the whole mess will be forgotten! Such is human nature!
    Reply
  •  
    Oct 07 01:20 PM
    I was just watching Fed Chairman Bernanke on TV... Man! His voice is really cracking... He sounds really scared...

    I'd hate to be in his position...

    He told the American people this $700 billion that this would work, next he told Congress the same thing -- now they are returning home to their constituents empty-handed with the markets still tanking. The shelf-life of the things this guy does is only a few minutes, if that.

    Everything he and Paulson and Bush do, actually make the markets worse because it gives the appearance things are spiraling out of control and that the government(s) have no influence. The Fed and the taxpayers are not going to be in a position to carry the world's economy on our back.
    Reply
  •  
    Oct 07 01:23 PM
    We haven't learned anything and I suspect we won't learn from this either.

    The actions being taken by government today seem unprecedented, but if you study the great depression you'll see that the actions taken then were just as interventionist and in some ways more so. Hoover and FDR took a fed created recession and turned it into the great depression.

    There's a good chance our current and near future "leaders" will take us down a similar path.

    Nope, we haven't learned anything.
    Reply
  •  
    Oct 07 01:34 PM
    I guess Bush could go to Wall Street today and ring the closing bell...

    Of course they would have a large banner that says:

    "MISSION ACCOMPLISHED"

    That may provide some confidence...
    Reply
  •  
    Oct 07 01:39 PM
    "government backed banking cartel" Does this raise any red flags? Wasn't the Fed supposed to eliminate the so called "business cycle"?

    I sure wish we would try "free market capitalism". Such a lovely idea. To bad we let "respectable bankers" and the government screw it up.
    Reply
  •  
    Oct 07 01:40 PM
    curbs-in, jut the thought of Bush ringing the closing bell had me rolling on the floor ( figuratively speaking that is ) and with his banner to boot-gotta love it
    Reply
  •  
    Oct 07 01:47 PM
    To James.

    I have done long thinking on why the Americans think they can avoid the rather natural downturn that comes with the economic cyclus.
    The main reason is that there is some thought like the economy is just a machine that can work 27/7 with only some maintainace every now and then.

    It goes even deeper; only the Americans have done extensive studies to the 24/7 soldier. All these projects doomed, soldiers are no machines but living tissue and after a few nights without sleep the brain simply cannot take it anymore.
    If it would be possible nature would have coughed that up millions of years ago.

    The most simple argument why the present FED policies will fail in a very hard way is very simple:

    For as long as the FED keeps quarterly records on the debt on the US financial sector (since 2001 if memory serves), this debt has expended exponentially at over 9% a year.
    Long term GDP growth is only 3% a year.
    Right now the financial sector debt is over one US GDP: 16507.5 billion US$ to be exact.

    From math we know that the biggest exponent always wins it so if the present FED policy stays in tact this debt will very soon be 20 trillion...
    Reply
  •  
    Oct 07 01:47 PM
    JohnAl,

    I agree... But this is an interesting situation... A Princeton economist put it best when he said this "isn't in the textbooks."

    Personally, I see this as an economic version of pre World War I. Prior to that war, countries throughout Europe and Asia had complex military alliances that committed them to do things based on other complex alliances with other countries. Archduke Franz Ferdinand is assassinated and... Bingo... World War I. They had treaties to enter into the war on one side or the other -- didn't matter that it was totally stupid. Didn't matter that Archduke Franz Ferdinand was inconsequential.

    Here we have the same thing... The global financial and economic system has developed a complex, interrelated system based on equally complex trade agreements. I think the economic version of Archduke Ferdinand has been assassinated and now comes the fun...
    Damned if you do, damed if you don't...

    The Fed can cut the rates to ZERO and he may get a small bump -- again... Shelf-life of anything the Fed/Treasury is nil at this point... At this point they may as well nationalize the banking system... Maybe that will work.
    Reply
  •  
    Oct 07 01:50 PM
    I noticed that several annalist also noticed the absolute fear in Bernanke's voice.

    That gives me a lot of confidence... Actually, I find it a bit disturbing.

    Well, When he started talking it was Dow -90 Now that he's finished... Dow -300

    The fear in Bernanke's voice did it for me. It seems a lot of people picked-up on it too.
    Reply
  •  
    Oct 07 01:50 PM
    There will always be excesses and deficiencies in the market and balance will always emerge to bring it back to the midpoint. I mean, what did people think was going to happen - the US consumer just keeps on consuming with negative savings and an inflated housing market?

    Recessions are necessary and a pain that no one enjoys enduring, but they are required. What I would rather have is a sharp & quick recession vs. something long & drawn out which, appears to me, is what we're getting with this current mess.
    Reply
  •  
    Oct 07 01:52 PM
    Emmm... -339 and still falling.

    Maybe one thing they should learn from this...

    Just shut up!
    Reply
  •  
    Oct 07 01:57 PM
    Thank you for this article. Somebody needs to step up and speak "in defense" of recession. It is the natural forest fire that cleans out the underbrush and allows new sprouts to grow and thrive. The thinking that we can have endless prosperity with no downside is dangerous to our economy and disastrous in the long term. Realizing when things have gotten out of hand on the upside is a skill that we should learn from this crisis.
    Reply
  •  
    Oct 07 02:03 PM
    One thing several people have reported recently,

    The U.S. Government and others have been shilling the markets at critical points, as well as dropping rumors a key points during the trading day using the the New York Times, Wall Street Journal and CNBC.

    If that information that was just reported is true, no we haven't learned anything. How pathetic!
    Reply
  •  
    Oct 07 02:07 PM
    "The fear in Bernanke's voice did it for me. It seems a lot of people picked-up on it too. "

    Ain't it wonderful that the world's economic system depends on ONE man? HAHAHA!
    Reply
  •  
    Oct 07 02:18 PM
    Good article, good comments.

    One point to play devil's advocate:

    "The great challenge for the years ahead is finding a [1] reasonable balance between promoting growth and prosperity while [2] allowing a prudent degree of excess trimming. This is a political question as much as it is an economic one."

    These goals are mutually exclusive. Politically 'promoting' growth would entail providing external agents which cause growth in places where it might not naturally occur (or occur with less vitality). This is directly counter to 'prudent trimming' (or eliminating that which is non-sustainable).

    The beauty of the unfettered marketplace is that ventures which have no meaninful demand will fail and cease to use valuable and scarce resources.

    You cannot 'promote' gains by unneeded ventures without failing to 'prune' it away. The market will prune it without outside help.
    Reply
  •  
    Oct 07 02:24 PM
    Again, the oligarchy still refuses to admit that the source of the problem is central banking, big government, and fiat currency. They have learned nothing and have nothing to offer.
    Reply
  •  
    Oct 07 02:25 PM
    moonbat1775

    Well... It's better than listening to Cramer! HA! HA!

    For me... When I hear someone on the "inside" with a background in academia -- unlike Paulson -- sounds like he's shaking in his boots, I wonder what he knows that I don't know. Or should I say, something that I don't know yet...
    Reply
  •  
    Oct 07 02:27 PM
    debtacid

    "They have learned nothing and have nothing to offer."

    Oh! They have plenty to offer... Financial ruin and the destruction of the free market system.
    Reply
  •  
    Oct 07 02:29 PM
    "Recessions are necessary and a pain that no one enjoys enduring, but they are required. What I would rather have is a sharp & quick recession vs. something long & drawn out which, appears to me, is what we're getting with this current mess. "

    Peter Schiff has been saying this for over two years .. people should have been ready for this.

    dansdeepcreekblog.blog...
    Reply
  •  
    Oct 07 02:42 PM
    "Well... It's better than listening to Cramer! HA! HA!" Curbs In

    Sure Bernanke is the ultimate insider and has real power to destroy the economy. That is the sad thing, that the so called "free market" has a single point failure point. But rather than cry, for now I choose to laugh at the spectacle of millions hanging on the words of a bald, frightened man. BTW, Bush should be bald if he had any sense of the damage he's done.
    Reply
  •  
    Oct 07 02:49 PM
    SAVING OUR ECONOMY ( FOX NEWS SPECIAL ) / 1 OF 6

    Watch all six of these on youtube.com to see a pretty telling report as to how we got into this mess. As usual, greed and dishonesty prevail in Washington. This is why we need less government involvment, not more.
    Reply
  •  
    Oct 07 03:03 PM
    I've learned something. Investment bankers have power enough to ruin capitalism through foolish choice. Who can't see we're using socialist methods of bail out that will only lead to more socialism down the road. Its all too clear to me that Fannie and Freddie will remain in government hands forever. Moral hazard will be renamed moral housing or some such thing. Voters are already leaning heavily on socializing medicine and anything else politicians can come up with. This is a race to mediocrity. Down this road, there's no turning back.
    Reply
  •  
    Oct 07 03:17 PM
    I dare to predict that the FED will eventually gain emergency powers to buy stocks directly in the marketplace.
    Reply
  •  
    Oct 07 03:22 PM
    This is NOT a natural downturn.

    CEO's were incentivized to gain short-term profits by destroying their companies and disasterously lowering credit standards.

    Also due to overly-rigid thinking and reliance on so-called "models" thousands of econ/math PhD's assured since people paid their mortgages for the past 5 yrs, they would keep doing it. Lemmings / "group think" / lies, damn lies, then there are statistics/models.

    Now have destroyed their companies, fled with multi-million severances, and starting distressed debt hedge funds (CEO Countrywide now heads PennyMAC), investors are rightly pissed off and don't want to invest.

    Now instead of dealing with the justifiable investor respsonse, we go crying to the FED, like a baby who brok its toy, mommy, fix-it!!!

    Of course, mommy will help her little baby, don't you cry...

    To conclude--the "cycle" in this case, as with the S&Ls, was simply due to the fallout of larceny/kleptocracy...... off investors, and then the natural, understandable response from investors sold AAA investments which are shit.

    To alleviate it in the future--see if Goldman Sachs (the Fed), will regulate itself, or maybe try a new administration...

    Reply
  •  
    Oct 07 03:33 PM
    It proves FREE MARKET does not work. What leads to this financial catastrophy is the phenonmenon that lenders were too greedy by lending too much money to people that obviously cant pay back.
    Reply
  •  
    Oct 07 03:36 PM
    We will see a more socialist model of economy after this financial crisis. Free market doesnt work in this 21th century world.
    Reply
  •  
    Oct 07 03:39 PM
    But there is no free market; there is a plutocracy / kleptocracy "gaming" the system...
    Reply
  •  
    Oct 07 03:44 PM
    To those bashing the free market: Please, please, please tell me:
    What part of "government backed fractional reserve banking cartel" sounds like the "free market"??

    Please get a clue and read Murray N. Rothbard's "The Mystery of Banking" available as a free download from mises.org.

    The central fractional reserve bankers have been doing it to us since 1694.
    Reply
  •  
    Oct 07 03:45 PM
    Apple at 60$. This was anything but a free market.

    1) Fannie/Freddie implicitly receive gov't guarantee on their paper.
    2) CRA put on steroids to ensure financially unqualified people can buy a house they can't afford
    3) FED lowered interest rates every time the economy slowed down a bit.

    If this HAD been a truly free market several of the parties involved would have gone bankrupt years ago before things got out of hand and we wouldn't have had everyone piling on a "sure thing" like we eventually got.

    Government and FED interventions in the market provided the incentives that were abused by amoral market participants with no regard for leverage or risk. That's what caused the mess.

    Reply
  •  
    Oct 07 03:45 PM
    When my professor in my eco 101 class gone over free market system, i already know its not going to work. We can't rely on supply and demand any more simply because human beings are born greedy and the era of internet that has made the market even easier to be manipulated. There should be a government body to oversee and stop businesses from becoming too greedy.
    Reply
  •  
    Oct 07 04:05 PM
    Free markets are what harness greed for the good of society. The fastest way to get stinking rich is to build or deliver something valuable to the public at a reasonable price.

    Henry Ford - cars
    Andrew Carnegie - steel
    David Rockefeller - Oil
    Commodore Vanderbuilt - shipping
    Bill Gates - software
    Sam Walton - "Low Prices - Always" Wal-Mart

    These guys and many other "greedy bast@rds" like them, all provided tremendous benefits to society and received mountains of money in return. Same holds today because of the free market, not because some government agency made sure they weren't cheating people.
    Reply
  •  
    Oct 07 04:08 PM
    The rapidly expanding debt of the U.S. can never be repaid except in the equivilent of Zimbabwe dollars. We all know this but continue to cash in and leave the future bill for others. "The emperor has no clothes". When that can no longer be denied, it will be a time, not just of recession, but of chaos. What to invest in? Food, guns, razor wire, lorazapam?
    Reply
  •  
    Oct 07 05:02 PM
    Well... over -500 down today...

    Turn that frown upside down my lurkers from Wall Street, the Fed, Bush Administration, et.al.

    At least they didn't stop trading...
    Reply
  •  
    Oct 07 05:11 PM
    Government interference in free markets is at the heart of this problem.

    The Community Reinvestment Act and GSEs are root causes.

    To those of you who say free markets do not work, you are wrong and unwilling to think for yourselves. Please read Hayek.

    The quicker we get to less government, the quicker more people will obtain wealth.

    I also recognize that people are afraid and want someone - government - to take care of them.

    This is what the socialists like Soros and Obama want. You are playing right into their hands. The only problem for you is that you are not among the elite and you are about to don the yoke of servitude. How sad for you and for the rest of us who will dragged under by your foolishness.

    Reply
  •  
    Oct 07 06:07 PM
    This article seems based on the premise of a correction taking place to the business cycle, with the business cycle as the cause. The very basic cause, as I understand it, to this economic crisis is the improper structuring of the market through lack of information, which the government is supposed to ensure.

    Financial markets require accurate information to be distributed equally. The housing crisis was caused by banks buying mortgage bundles rated at an inaccurately rated level which then lost tremendous value. The banks relied on that information, which could have been prevented by reasonable government regulation.

    Properly structured free markets are always the way to go, but if someone really wants leverage their neck into a noose, they should be allowed to do so.
    Reply
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