Trickle down biology

Though few in number, they have an effect that affects the whole system for the better.

Quotes

From This Time Is Different: Eight Centuries of Financial Folly, Carmen M. Reinhart and Kenneth S. Rogoff, Princeton, 2009, 

If there is one common theme to the vast range of crises we consider in this book, it is that excessive debt accumulation, whether it be by the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom. xxv

Although private debt certainly plays a key role in many crises, government debt is far more often the underlying problem across the wide range of financial crises we examine. xxxiii

Severe financial crises rarely occur in isolation. Rather than being the trigger of recession, they are more often an amplification mechanism: a reversal of fortunes in output growth leads to a string of defaults on bank loans, forcing a pullback on other bank lending, which leads to further output falls and repayment problems, and so on. 145

[I]nflation has long been the weapon of choice in sovereign defaults of domestic debt and, where possible, on international debt. 175

A double dip prediction

The Economic Cycle Research Institute says we are heading for a new recession:

Early last week, ECRI notified clients that the U.S. economy is indeed tipping into a new recession. And there’s nothing that policy makers can do to head it off.
....
Why should ECRI’s recession call be heeded? Perhaps because, as The Economist has noted, we’ve correctly called three recessions without any false alarms in-between.
....
A new recession isn’t simply a statistical event. It’s a vicious cycle that, once started, must run its course.
....
It’s important to understand that recession doesn’t mean a bad economy – we’ve had that for years now. It means an economy that keeps worsening, because it’s locked into a vicious cycle. It means that the jobless rate, already above 9%, will go much higher, and the federal budget deficit, already above a trillion dollars, will soar. 

Procyclical policy?

The regulatory authorities lowered capital requirements during the boom and now want to raise them during the bust. A reaction:

Bove points out that the proposal, which he dubs absurd, would “effectively take U.S. banks out of the financial system for an extended period. It would have a similar impact on the economy as the Fed’s two reserve ratio increases in 1937 which plunged the United States back into depression.”

Two in one

Two of my favorite ideas, feedback and the importance of rent-seeking, made it into a book review at The Wall Street Journal. The book in question was asking why Great Britain was the first to industrialize.

Mr. Mokyr's answer—articulated in densely packed but gratifyingly lucid prose—is that in Britain ideas interacted vigorously with business interests in "a positive feedback loop that created the greatest sea change in economic history since the advent of culture."
....
The reason for Britain's exceptionalism, Mr. Mokyr says, lies in the increasing hostility to rent-seeking—the use of political power to redistribute rather than create wealth—among the country's most important intellectuals in the second half of the 18th century. Indeed, a host of liberal ideas, in the classic sense, took hold: the rejection of mercantilism's closed markets, the weakening of guilds and the expansion of internal free trade, and robust physical and intellectual property rights all put Britain far ahead of France, where violent revolution was needed to disrupt the privileges of the old regime.

Implicit in this argument is that countries that cannot develop are locked in a rent-seeking trap, and my limited knowledge of economic develop suggests that is a plausible argument. Unfortunately, rent seeking seems to be increasing in the U.S. If there a feedback loop in which rent-seeking in some way creates more rent seeking, then deep pessimism is in order.

(found via Newmarks Door.

Meritocracy and feedback

Ross Douthat suggests a pessimistic feedback loop, that complex systems tend to become increasingly complex because they cause ever increasing problems:

This is the perverse logic of meritocracy. Once a system grows sufficiently complex, it doesn’t matter how badly our best and brightest foul things up. Every crisis increases their authority, because they seem to be the only ones who understand the system well enough to fix it.

But their fixes tend to make the system even more complex and centralized, and more vulnerable to the next national-security surprise, the next natural disaster, the next economic crisis. Which is why, despite all the populist backlash and all the promises from Washington, this isn’t the end of the “too big to fail” era. It’s the beginning. 

Found on the Econlog.

The Greek tragedy

At The American Interest, Walter Russell Mead reflects on the situation in Greece and the difficulties limitations that culture imposes on a country's development:

The Greeks are a highly cultured people; the most popular slogan at the rallies was “The Croesuses should pay.”  Croesus was, of course, the extremely wealthy king of Lydia whose story appears in Herodotus.  The point of the protesters is that the rich should pay the costs of the economic crisis not the ‘blameless’ ordinary people whose only sin is to have voted for generations of demagogic politicians who promised to give them the moon and pay for it with other people’s money.
....
Greece is one of those countries like Argentina where conspiracy theories are widely seen as important intellectual breakthroughs.  As in Egypt and Russia, in Greece only a fool believes anything that authorities say; it must all be deconstructed to reveal the plots within.
....
In many parts of the world it is easy to spot a vicious cycle at work.  Because a country or a culture missed the visit of either or both of the two modernization good fairies (geography and culture) it starts out handicapped in the race to master capitalism and control their own destiny.  As a result, they fall behind, and lose power and control to other, faster rivals.  Capitalism becomes ever less popular, ever more associated in the public mind with a world system felt to be wrong and unfair.  Those feelings of alienation make it steadily harder for the country to adopt and follow the policies that could reverse the cycle and bring it success.  And so it goes.

Read the whole thing.  

Update: Riots with protesters killing innocent bystanders.

Feedback and climate change

My guess is that few people realize how important the concept of feedback is to climate change. A recent article in the Wall Street Journal explains its importance:

It is generally accepted that a doubling of CO2 will only produce a change of about two degrees Fahrenheit if all else is held constant. This is unlikely to be much to worry about.
Yet current climate models predict much higher sensitivities. They do so because in these models, the main greenhouse substances (water vapor and clouds) act to amplify anything that CO2 does. This is referred to as positive feedback. But as the IPCC notes, clouds continue to be a source of major uncertainty in current models. Since clouds and water vapor are intimately related, the IPCC claim that they are more confident about water vapor is quite implausible.
There is some evidence of a positive feedback effect for water vapor in cloud-free regions, but a major part of any water-vapor feedback would have to acknowledge that cloud-free areas are always changing, and this remains an unknown. At this point, few scientists would argue that the science is settled. In particular, the question remains as to whether water vapor and clouds have positive or negative feedbacks.
The notion that the earth's climate is dominated by positive feedbacks is intuitively implausible, and the history of the earth's climate offers some guidance on this matter. About 2.5 billion years ago, the sun was 20%-30% less bright than now (compare this with the 2% perturbation that a doubling of CO2 would produce), and yet the evidence is that the oceans were unfrozen at the time, and that temperatures might not have been very different from today's. Carl Sagan in the 1970s referred to this as the "Early Faint Sun Paradox."
For more than 30 years there have been attempts to resolve the paradox with greenhouse gases. Some have suggested CO2—but the amount needed was thousands of times greater than present levels and incompatible with geological evidence. Methane also proved unlikely. It turns out that increased thin cirrus cloud coverage in the tropics readily resolves the paradox—but only if the clouds constitute a negative feedback. In present terms this means that they would diminish rather than enhance the impact of CO2.

If the EPA can regulate carbon dioxide because of the greenhouse effect, could it also regulate water vapor?

An unemployment feedback loop

From an AP article:

Employers already are squeezed by tight credit, rising health care costs, wary consumers and a higher minimum wage. Now, the surging jobless rate is imposing another cost. It's forcing higher state taxes on companies to pay for unemployment insurance claims.
Some employers say the extra costs make them less likely to hire. That could be a worrisome sign for the economic recovery, because small businesses create about 60 percent of new jobs. Other employers say they'll cut or freeze pay.

 More unemployment raises unemployment insurance costs for employers, making them less willing to hire, causing more unemployment--a positive-feedback loop or, in the terms popular in macroeconomics, an automatic destabilizer.

Market rally

The stock market is rallying today:

Financial stocks led the rally, getting a big boost after the Financial Accounting Standards Board relaxed accounting rules forcing banks to value their assets at current prices. The change should help banks reduce losses.

And from another report:

The Financial Accounting Standards Board announced changes to accounting rules regarding mortgage-backed toxic assets on the books of many financial institutions. The rules, known as mark-to-market, were making it difficult for banks to value the assets and sell them at a fair value in the marketplace.

Investors greeted the rules change with a rousing move higher in the markets that had some talking about a long-term turnaround.

"These rules were absolutely the single biggest factor causing the complete turmoil in the credit markets," said Chip Hanlon, president of Delta Global Advisors in Huntington Beach, Calif. "This changes everything."

Wouldn't it be interesting if, when we get the time to view this panic and recession in hindsight, we decide that the panic and seizing up of financial markets would have been avoided if the mark-to-market accounting and capital requirements had been implemented in a different way? Think of the implications of the position that it was bad regulation that caused the mess.

WSJ on mark-to-market regulation

Harold Jenkins reports on what Warren Buffet said, but CNBC cut out, in his recent interview with CNBC:

CNBC, sadly, has been playing a loop of Mr. Buffett's remarks that does a consummate job of leaving out his most important point. Nobody cares about the merits of mark-to-market in the abstract, but how it impacts our current banking crisis. And his exact words were that it is "gasoline on the fire in terms of financial institutions."

The American Spectator has had a series of articles on the topic.

Fisher in the news

A few days ago economist.com had an article about Irving Fisher, who argued that a feedback cycle involving deflation and debt was a source of the Great Depression.

And he developed his debt-deflation theory. In 1933 in Econometrica, published by the Econometric Society, which he co-founded, he described debt deflation as a sequence of distress-selling, falling asset prices, rising real interest rates, more distress-selling, falling velocity, declining net worth, rising bankruptcies, bank runs, curtailment of credit, dumping of assets by banks, growing distrust and hoarding.

Fisher was also one of the great monetarist, the Milton Friedman of the early 20th century.

Time to delete mark-to-market?

There were rumors on Friday that the mark-to-market rules might be relaxed, and those rumors were credited with the rise in bank stocks.

Which leads to the question, why are those rules still in place? There have been suggestions throughout the financial panic that the mark-to-market rules were one of the things that was accentuating the fall. And if we look at how the Federal Reserve has responded, we can see that this financial panic is like no other. What is different this time? Could it be that the mark-to-market rules have introduced amplifying feedback, making the financial crisis a self-feeding process?

When FDR became president, his administration was a lot like the character in a comedy reacting to a crisis by pushing buttons. FDR pushed a lot of wrong buttons, but he did push one correct button by severing the tie to gold and eliminating the Fed from monetary policy, which had established an amplifying feedback loop in monetary policy. Maybe the mark-to-market button is the right one this time. Certainly it is worth trying. If the U.S. is willing to spend nearly two trillion dollars, the amount of the TARP and the so-called stimulus plan, why would it not also be willing to junk a rule that costs virtually nothing at all to junk? I wonder why the Bush administration was never willing to take this simple step given that they were willing other steps that were far more drastic.

Economics lacks a consensus framework in which to view macroeconomics. A framework of shocks and feedback, in which shocks knock the economy off path and the feedback accentuates the effect of the shock, leads one to focus on items like mark-to-market. The equilibrium approach of Keynesian economics leads to a focus on stimulus packages. If we get both a stimulus package and an elimination of mark-to-market, it may be very difficult to distinguish the effects of each.

Update Feb 16, 2009: Brian Wesbury, chief economist at First Trust Portfolios L.P., argues in a National Review piece, "Untouchable Accounting Rules? Really?", that mark-to-market has been a major contributor to the current crisis because of its procyclical feedback properties, and needs to be eliminated. He points to some history:

Fair-value accounting as we know it today is based on rule FAS 157, which was implemented by the FASB in 2007. But it has a longer history than that. Fair-value accounting existed in the 1930s, which was when we had the Great Depression. In 1938, President Roosevelt suspended those rules, and between then and 2007 the economy had no panics or depressions. Maybe its time we put fair value through the shredder once again.

Stimulus and the Great Depression

The Huffington Post has an article about the two views of the Great Depression,

The dominant story in the public mind is of President Franklin Delano Roosevelt's success. It goes like this. Like Obama, FDR comes to power with the American economy haemorrhaging jobs. He believed that, if private industry is withering, the government has to take up the slack by large public spending programmes. He set millions to work preserving green spaces and rebuilding the country's infrastructure.

The other view is attributed to a small number of right-wing economists in the 1980s.

They argued that the American people had been wrong: the New Deal actually made the Depression worse. By borrowing and spending so much, the government created a climate of uncertainty. This made investors hold on to their money - prolonging the despair. It didn't restore private investment, it "crowded it out".

The author, Johann Hari. then argues the first is correct for two reasons. First, when FDR cut back spending and raised taxes in 1936, we had relapse. Second, it was the spending of WWII that finally ended the Depression.

The article skips the interesting questions that are needed to frame the whole debate. We have had recessions every few years for the past two centuries. Most of them have been mild. Nothing else was close to being as severe or as long-lasting as the Great Depression. Why was it so deep? At the time, many thought it revealed an inherent flaw in capitalism, that it showed that Marx was correct. A large part of the intellectual class that grew up in that era accepted this explanation and became Marxist. But when there was no depression after World War II, despite the predictions of people such as Paul Samuelson, an ardent Keynesian, people had to start looking for other explanations. The most convincing explanation that has emerged is a monetary interpretation, arguing that the Great Depression was special because government policy set up an amplifying feedback loop. As things became worse, government (monetary) policy changed to make it even worse, etc. That loop was not broken until FDR neutered the Federal Reserve by abandoning gold. There remains disagreement among economists as to the importance of the real-bills doctrine and the gold standard in contributing to that feedback loop, but most economists who have looked at the episode with any care now see Federal Reserve policy as key to understanding the decline from 1929 to 1933, and also the sharp recession in 1936-7 when the Fed raised reserve requirements. This explanation was developed and popularized by Milton Friedman and Anna Schwarz, but it can be found far earlier, in, for example, a book by Lauchlin Currie.

Compared with other recoveries, the recovery after 1933 was slow. Why was this recovery so slow? One answer, favored by the left, is that because the fall was so deep, normal resiliency of markets was impaired, and government policy was needed. The New Deal was doing the right thing, but just not enough of it. On the other side, the conservative answer focuses not only on expectations and uncertainty (though not primarily caused by borrowing and spending), but also on interference with markets. When a market has a surplus, either a fall in price or an increase in demand will restore market clearing. If there is no increase in demand, then an attempt to keep price from falling will stop that market from finding an equilibrium. In a system of markets, preventing some markets from adjusting can keep the entire system from re-adjusting. The New Deal interfered with price adjustment in many ways--various programs attacked a symptom of recession (deflation), not the cause (insufficient demand). Hence, it is only natural for economists to argue that some New Deal policies made the problems worse rather than better.

The first rule of medicine is, "First, do no harm." It should also be the first rule of economic policy making. Economists have made a convincing case that government policies during the Great Depression did harm. Hari does not seem to take seriously the possibility that the stimulus package being discussed in Washington could do more harm than good.

(If Johann Hari is correct on what got us out of the Depression, shouldn't he be advocating a massive expansion of the military?)

Update: The Wall Street Journal has an piece dated Feb 2, 2006 by economists Harold Cole and Lee Ohanian that emphasizes the negative role of the New Deal's attempts to micromanage markets.

Obama on the recession

An AP story reports:

President-elect Barack Obama said Thursday the recession could "linger for years" unless Congress pumps unprecedented sums from Washington into the economy.

That is a very Keynesian view, a belief that the economy lacks strong stabilizing forces. I live in the other camp, the camp that thinks that the economy has strong stabilizing forces over a period of a few years, and the greatest danger is destabilization from the government. What is rather odd is that both views look to the Great Depression for support.

Gullibility and Madoff

In a long but fascinating article about gullibility, Steven Greenspan explains how he invested a large amount of money with Bernie Madoff. He even talks about feedback in several places.

Mr. Shiller employs a social psychological explanation that he terms the "feedback loop theory of investor bubbles." Simply stated, the fact that so many people seem to be making big profits on the investment, and telling others about their good fortune, makes the investment seem safe and too good to pass up.

Global warming at Huffington

There is an article debunking global warming at the Huffington Post, of all places. It has lots of comments. And, of course, it discusses feedback, which is the central issue of global warming debates.

Fiscal stimulus skeptics

Greg Mankiw had a post a while back that quoted part of an AP story identifying him as the only skeptic of a planned massive Obama stimulus package. He then followed up with a couple of other posts. There are, of course, many more skeptics than Mankiw. Skepticism seems in order partly because the evidence is that the Keynesian multiplier is low, and even more because of public-choice considerations, some of which are discussed in a Wall Street Journal commentary. For me the highlight of this commentary was its discussion of feedback, the possibility that bad economic results lead to bad policy, leading to even worse results.

Biggest Ponzi scheme ever?

Today there were reports of an arrest of a legendary Wall Street trader for fraud.

"It appears that at least $15 billion of wealth, much of which was concentrated in Southern Florida and New York City, has gone to 'money heaven.''

Bernard L. Madoff is accused of running a Ponzi scheme, in which he used money of later investors to pay off earlier investors. It appears that many hedge funds had entrusted money to him. Small investors will be hurt by this only indirectly since his investors were either wealthy or were institutions. Hedge funds are an investment opportunity for the rich, not for ordinary people.

Periods of market stress are the times when fraudulent firms and schemes often come to light. It is easier to hide fraud in bull markets. Perhaps this is another element of feedback in downturns.

Update 1: Here is an AP article on the range of people affected

Stories of the panic

Steven Landsburg wrote, "Most of economics can be summed up in four words: 'People respond to incentives.' The rest is commentary."

Peter J Walliston has been doing commentary, arguing that the incentives created by the government in its attempt to use markets to pursue social aims are the source of the current financial meltdown.

...U.S. housing policies are the root cause of the current financial crisis. Other players...played a part, but they were only following the economic incentives that government policy laid out for them.

Does it matter how we interpret events such as the current financial mess? Interpretation certainly mattered in the 1930s, when the predominant story was that the Great Depression was a failure of the market. That interpretation justified a many government programs and created a generation of socialist intellectuals. After World War II when decolonization took place, that interpretation led to many of the new nations pursuing socialist policies, with disastrous results.

The story that the current financial mess is the result of deregulation, which is popular in some parts of the press, is also a story that the market failed, and it logically leads to larger government. A story that government involvement led to the current crisis has completely different implications.

A major achievement of Milton Friedman was a convincing argument that the Great Depression represented a failure of government policy. The Federal Reserve pursued a procyclical rather than a countercyclical monetary policy. Without this reinterpretation of the Great Depression, the Ronald Reagan presidency would not have been possible. Keynes was right about the power of ideas.