Thursday, November 27, 2008

Economics Isn't Science

So first, this clip is just fun to watch.  I have said before that perhaps the best indicator for how to invest is to do the opposite of whatever the talking heads on CNBC are saying to do.

(And I do have to call out the left wing media where it is full of crap -- the idiotic boosterism being put out on these shows is not particularly "right wing" and this is not a right-wing media issue or a Fox News issue...this is a Wall Street industry issue.  Heck, I've heard both Democrats and Republicans try to blame each other for the current financial mess - I don't buy a word of it. For a blow up of this magnitude, everyone has to screw up at once.)

But while Peter Schiff did seem to call the crash correctly, I don't think that his proposed solution is a very good idea (even though he is right about borrowing money to live beyond our means). His idea is to cut government spending, and the fact that he thinks that this is a good idea reveals a major ideological divide within economics between the Keynesians and the Friedmanites.  (These schools of thought do often correspond with left wing and right wing from a political perspective, Schiff's economics are conservative, or more accurately perhaps libertarian.)

The Keynesians would point out that as everyone braces for a recession, demand is going to fall, and demand falling will cause supply to fall, causing a feedback loop.  I know I might get laid off, so I stop buying corn the guy who works at General Mills gets laid off and stops buying X-Plane and now I am laid off - because I prepared for that event - a self fulfilling prophecy.  The Keynesians say that in this circumstance it is important for governments to spend money to help break the feedback loop.

The Friedmanites would argue that efficient economic activity cannot resume until prices have normalized - in order for us to have real growth, we can't have incorrectly priced (too expensive) houses, etc.  Therefore the best thing the government can do is get the hell out of the way, let prices fall until they make some sense, and only then can we get back to having a productive economy -- until that point, investment will be going in the wrong places and be wasted investment, hurting our long term future growth.

The problem is that the Keynesians and Friedmanites, while both probably at least partially correct, have completely opposite prescriptions about what to do.  You can't really do both. And we can't do an experiment where we try both separately to see which advice works better. This is why no one can agree on which theory might be correct (or at least more correct): we can't do the experiment to disprove the theory.*

How do we reconcile these?  Benoit Mandelbrot points out that market pricing isn't the stable equilibrium we think it is - free market prices simply go completely nuts sometimes.  Behavior Economists are starting to explore why this might happen, but one thing is clear: prices sort themselves out eventually, but in the interim they can show periods of extreme weirdness.

So I would say that in looking at housing prices, government policy has to consider both sides of the economic coin:
  • Housing prices may become very wrong for periods of time.  We saw our houses become very highly overvalued.  I believe they will swing the opposite way and become highly undervalued.  Buyers have a lot of (partly irrational) fear of buying before we "hit bottom"; this means that the bottom of housing prices will be lower than their natural support level and will then bounce back up, as buyers refuse to buy until they see the bottom.
  • On the other hand, houses do need to eventually hit a sane level - there is no other way to have a functioning economy.  No policy that preserves housing prices as they were can make any sense.  (We don't need any more houses - any policy that artificially raises the price of houses and causes more to be built is wasting investment and hurting future useful economic growth that should be happening in other areas.)
I don't think there can be a really good solution to the housing problem, because the only real solution would be to go back in time and stop people from making a number of poor decisions based on incorrect pricing and incorrect assumptions.  But the money has been spent, the houses have been built, and we're stuck where we are.  So all we can do is be pragmatic and try to make the situation as not-bad as possible with very limited tools and a lot of constraints.

* Being a congenital left-winger I am more sympathetic to Keynesian than Friedmanite particular my complaint is this: because in Friedmanite thinking a central bank fundamentally screws up economic equilibrium, Friedmanites will be able to blame the Federal Reserve for all ills, even if Friedmanite policy is enacted, thus their theory can never be proven wrong by actually trying it.  That is, unless we get rid of the Federal Reserve.

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