Hoisted from the archives – my old post on Freshwater and Saltwater macroeconomic theory
Long before Paul Krugman elevated the central schism in macroeconomics to the front page I wrote about it on this blog.
My old post is reprinted below (with a few trivial modifications to make it more readable than the original):
Freshwater and Saltwater: macroeconomic theory and losing money
Background for the non economists. In 1976 Robert Hall christened the central schism in macroeconomic thought as being between the freshwater and saltwater schools. The division was picked by their location (on the Great Lakes and Rivers versus the coastal schools). The division exists today – and indeed is being played out in Krugman’s (saltwater) blog and by the Chicago economists who think he is a bozo idiot.
Having got through the background here is the post…
Does everyone agree that Greenspan kept monetary policy too loose for too long?
I thought so!
When I did economics at University (admittedly at that Freshwater school on the Molonglo River called the Australian National University) that was meant to end in inflation – not deflation.
I like my theory to accord at least loosely with reality. Especially if I am going to bet real money on the outcome – rather than pontificate in papers from the ivory tower of academia.
More to the point – I thought (in true Freshwater style) that sustained low interest rates were a sign that monetary policy had been tight and that sustained high interest rates were a sign that monetary policy had been loose.
Given that basic understanding of macroeconomics I thought that regional banks that made more than half their profits out of carrying the yield curve would be carted out when loose monetary policy did eventually lead to higher interest rates. I was short a lot of banks – and whilst that was good – I spent a long time being short interest rate plays (whereas I should have been short the credit sensitive banks). I have detailed that mistake here. Bill Gross made a similar mistake declaring (early) the 25 year bull market in long dated treasuries over – so despite Bill Gross’s saltwater location at Newport Beach I was wrong in good company.
Now the subject of freshwater, saltwater and other macroeconomic elixirs is the subject de-jour amongst economic bloggers – but I have conducted the experiment – with real money – and I can confidently say (brutally backed by less-than-ideal-financial outcomes) that the saltwater guys were right.
John Hempton
PS. I know that the inflation junkies are still predicting hyper-inflation – but they were also predicting it in January when I wrote the original post. The Freshwater guys are still wrong. Will the backers of the Freshwater school please put out a testable timetable?
PPS. A reasonable summary of the issues I lived can be found in Justin Fox’s book. Whether Krugman should have referenced Fox in his magazine article is an open question – but I think Fox’s summary is right… Krugman lived the issues in the book and did not need Justin Fox to explain them to him…
Read more at John Hempton's Weblog
By the way, is one of the lessons here that Justin Fox is that damned good?
September 17, 2009 12:33 AM | Reply | Permalink
And don't forget the Austrian-school, which is the No-Water school (one of the chief proponents, Murray Rothbard, taught at the University of Las Vegas).
Of course, what people are ignoring is that we had massive inflation throughout the 00s. It's just that the pricing effects were mostly concentrated in home prices.
The current deflation is largely a correction. The main reason we do not yet have inflation is that banks are not yet lending out a lot of the money.
Despite anger at banks for sitting on their money rather than spending it and stimulating the economy, bank reticence to lend is what has kept 70s-level stagflation at bay.
September 17, 2009 12:41 AM | Reply | Permalink
Desert economists? :-)
Joking aside -- given the current extent of slack in all economic factors it's hard to imagine that the banks could create inflation by relaxing their lending standards.
I'd rather see you analyze the current situation in terms of adjustments of time preferences.
September 17, 2009 2:06 AM | Reply | Permalink
That's absolutely right. Just because policy that was too loose for too long didn't cause goods inflation or wage inflation but instead asset inflation it was still inflation until the bubble popped.
Stagnant wages (caused by Chinese labor) created an illusory tame appearance of consumer goods' prices which, in turn, made Greenspan feel as if he had whipped the cycle into submission. Pride cometh before the fall.
September 17, 2009 8:33 AM | Reply | Permalink
From Bill Woolsey, who teaches economics at The Citadel:
Perhaps part of the problem we face in macroeconomics today is that a substantial part of the "macro" wing of free market economists [that is, those "fresh water" economists] really think that new classical macroeconomics is "true" because simple and formalistically complete models fit their notion of what is scientific.
September 17, 2009 1:49 AM | Reply | Permalink
Economics can be scientific. But it has to be a little more complicated than, say, molecular biology.
September 17, 2009 11:18 AM | Reply | Permalink
We just found out that the freshwater isn't fit for consumption. It would be in a perfect world...but what worlds are ever all that?
September 17, 2009 2:30 AM | Reply | Permalink
In due time, it may not matter whether one believes in the freshwater or saltwater concepts. The next two "scheduled" events are the G-20 and Sept.30. The G-20 meeting has the potential to be a free for all and/or an absolute pounding of U.S. policy. The world has called for a new reserve currency and or one that has Gold backing.
Any movement from the current status quo will be U.S. and thus Dollar negative. A move toward a different, but still a fiat reserve currency will reduce Dollar demand but not solve the current problem of "non settlement". It will also pose the ever present fiat flaw that whoever issues this new currency will be tempted to print wildly and "blow" new bubbles.
If you have ever owned a dog before you may have seen it "cower" in a dangerous situation. If you have ever seen 2 or more dogs in this same situation then you know that as few as two dogs can become an instant "pack". In other words when someone has your back you tend to grow taller or have more confidence. This is the problem that the U.S. delegation is going to face, they (and Britain) will be on one side of the table and the ROW will be on the other. This G-20 meeting could resemble Custer's last stand if for no other reason than timing.
I say "timing" because Sept. 30th is only several days in the future. Sept. 30th is the fiscal year end for the U.S. Treasury. It is also the date when ALL banks across the globe must become Basel II and Basel III compliant. This is very important because any bank not compliant will not be allowed to trade outside of their borders with any bank nor within their borders with a Basel II + III bank.
Because of the massive "off balance sheet" derivative exposure that U.S. banks have, Basel III compliancy is an impossibility. This situation will simply expose the entire U.S. banking system to the truth, THE SYSTEM IS BANKRUPT all the way to the top!
As for the fiscal year end, what more can I say than the Chinese and Japanese have already said. Another year and another $ trillion or two is the funding requirement for the Treasury. The Asians will not provide more capital which leaves the Fed as buyer (lender) of last resort. The world knows this and apparently so do the markets as evidenced by $1,000+
Gold and the withering Dollar. Please keep in mind that huge resistance to Gold and support for the Dollar in the futures markets has only slowed these moves and not reversed them as the markets are finally showing that they are bigger than governments.
Can the U.S. postpone Basel II + III? I don't think so. Can they continue to postpone true "mark to market"? Probably not. Can the U.S. stand tall in a world where money is backed by Gold? In my opinion it is currently impossible. I believe the pending moves will be so violent and swift that worldwide market closures will become inevitable.
The music is winding down rapidly and you MUST have a chair and be seated in it BEFORE this comes to head. The entire process has taken longer than I thought it would, however it has proceeded as predicted and is now festering in the balance sheets of the banks, the Fed and the Treasury. We are "very late stage" now and the world will not be pushed around any longer. A very dangerous recipe if your net worth consists of Dollar securities.
September 17, 2009 12:13 PM | Reply | Permalink
Hempton's earlier post (1/2009) was occasioned by the argument that developed over whether a stimulus package could grow the economy. FW economists said "No" (Barro, Ricardian equivalence); SW economists said "Yes" (Keynes).
The argument that Krugman's Sunday Times article generated is over the question of why macroeconomists failed to see that the economy was headed over a cliff. Why didn't their models warn them?
Krugman claims the models failed to account for human emotions. As Merrill implies, above, if that's the case economists who are in the business of handing out policy advice -- both SW and FW economists -- should consider retiring. Not gonna happen; too complicated.
There have to be better answers -- and inflation and deflation, interest rates, and monetary policy aren't significant variables and won't be part of them.
The question is how do we know when we're approaching a "Minsky moment"? Or to ask it differently how do we know when debt has grown to a level such that the economy can no longer support it without going Ponzi -- that is, relying on increasing asset prices to bail us out of our debt obligations because we can't earn our way out.
Do either FW or SW macroeconomists have an answer?
September 17, 2009 12:44 PM | Reply | Permalink
Looking at this chart* at what date should economists have "known" that the debt was approaching the level at which it could not be serviced (and should not be refinanced)?
* Note: only 69% of homeowners carry a mortgage.
September 17, 2009 1:13 PM | Reply | Permalink
1) First and foremost, do whatever it takes monetarily and fiscally, including that mixture of both;debt monetization in order to prevent a 'hardening' of deflationary expectation among economic actors.
2) Use the central bank's balance sheet to hold illiquid assets 'in stasis' and trickle them back into the marketplace only when feasible.
3) Reestablish clear, thick barriers between commercial and investment banking. Support commercial banking through loan guarantees, regulate the crap out of investment banking with the least strictures on vanilla stock and bond investment through cash accounts and adding more reg as you go up the risk curve(margin accounts, listed derivatives, OTC derivatives).
4) As quickly as prudent, delist Fannie and Freddie and restore them to what they were. Then, over time shrink their balance sheets.
September 17, 2009 1:26 PM | Reply | Permalink
The way forward is pretty simple.
US financial institutions got caught with a lot of bad debt on their books due to lending too much to American consumers and businesses that were not creditworthy. They didn't intend for this bad debt to be on their books, since they attempted to sell it on to investors and foreign banks, with the least saleable pieces firewalled off in SIVs in the Cayman Islands, etc. However, they found out that they couldn't stick all their major customers and counterparties with the bad debt and stay in business, so the firewalls melted as soon as the crisis hit. Furthermore, many holders of this debt had secured insurance on the debt from AIG and other financial institutions. In the end, the US simply didn't have the guts to stick it to the final lenders, in part because that would have immediately shut off foreign credit and trade, followed by the collapse of WalMart, et. al.
So, the Federal Reserve and Treasury restored order by swapping treasury bonds for some of the debt and by providing government guarantees for some of the rest. They also have to provide similar mechanisms for new debt, since investors foreign and domestic are unwilling to purchase debt with thought a Fed or Treasury credit default swap attached.
As time passes, the Fed and Treasury have 3 options for paying off the debt:
1. collect the principle and interest from the consumers and businesses, or
2a. borrow more money,
2b. collect taxes, and
2c. create money.
2a and 2b slow the economy and deflate prices by withdrawing money, except in the case of 2a when the lender is foreign. However, 2a is disadvantageous in that the money had to be repaid.
2c speeds up the economy and inflates prices, except when the recipient of the money is foreign. Thus, 2c can offset the slowing effect of 2a and 2b.
So all they really need to do is get the combination of these three right.
As for Freddie and Fannie, I doubt that investors will regard the US homeowner as creditworthy without a government guarantee for a long time.
September 17, 2009 4:48 PM | Reply | Permalink
* Yes, Greenspan kept interest rates too low for too long.
* Yes, the GOPers systematically dismantled regulatory oversight.
* Yes, Americans lived too far beyond their means for too long.
Next debate?
September 17, 2009 9:58 PM | Reply | Permalink