5 – THE ELEPHANTS GATHER
My wife Mary and I once spent a day at Chicago’s Museum of Natural History. We’d seen a lot in the morning and were ready for some lunch. The grand stairway down to the cafeteria led through a large rotunda. We rushed down and made it just before closing time. Refreshed, we headed back for another go. We were astounded to discover there was an elephant in the rotunda, posed with trunk upraised. Not a dinosaur, but an elephant. In our haste for food and a place to sit, neither of us had seen it! How could we not notice? It was a moment of Zen. Yes, there was an elephant in the room; a modern proverb. And yes, it happens to others. In a televised Republican primary contest in 2012, candidate Mitt Romney was debating Texas Governor Rick Perry. At one point Romney said, “I’ll bet you $10,000.” “I’ll betcha ten bucks” would have been more like it. Millions of viewers sat up and noticed. The emperor was wearing no clothes. Some people just don’t seem to get it. Why couldn’t he see the elephant in the room?
And, it’s not just politicians. For years, elephants have roamed the halls where economists hang out but have not been noticed. Two big ones were Emotional Consumer and Private Debt. And, of course, there was their disreputable cousin, Dirty Money. Him and his awful friends! It was best not to mess with any of them. Economists appeared to ignore them. Pretend that debts and assets always cancelled out. Assume that people made rational economic decisions. Believe that the books were never cooked. Well, not really, but good enough to work with. Economists knew about these elephants, of course, but they were over there somewhere – not around here.
What economists understood were really, really and truly, free markets, and comparative advantage in trade between honest people. Little progress was made in tackling bigger problems or in predicting real-world outcomes until well into the 20th century.
On Black Monday in October, 1929, the huge elephant named Private Debt stirred himself and thundered through the economy on a rampage. Much of the money borrowed to buy stocks on margin couldn’t be repaid when the market dropped, so it fell even further. The elephant’s previous attacks had been hard to ignore but economists did so until the Great Depression arrived in 1930. So-called ‘panics’ had occurred before in 1873 and 1903. (The softer term ‘depression’ was coined in the 1930s.) All of them were like earthquakes – they just happened. No one saw them coming, knew why they happened, or what to do when they hit. American economist Irving Fisher had a moment of fame by remarking in 1928 that “Stock prices have reached what looks like a permanently high plateau.” Poor guy. Afterward he turned around and published a classic paper on debt deflation, explaining how falling prices raised the burden of debts, forcing asset sales thus pushing their prices down further, causing a self-reinforcing downward movement. No equilibrium here. The Great Depression was so awful that economists had to think anew.
In looking back through this history, I had to ask how debt could continue to ruin businesses and entire countries yet not be noticed by economic theory? Empires have been built and destroyed by debt. It has fueled wars all through history with huge economic and social consequences. Debt is built into today’s economy and is necessary for its functioning. Nearly everyone recognizes this. Ordinary people use credit cards, auto loans and home mortgages. Businesses use bonds and loans for financing. Politicians rant about the national debt. Without debt the economy would be reduced to near-barter, with money merely assisting in the exchange of goods and services. How can economists believe that because all debts have matching assets, debt has no bearing on their economic models? I think it’s because their models are static, frozen in time, always in equilibrium. The big Debt elephant is merely a taxidermist’s exhibit, stuffed and posed with trunk upraised. It can be safely ignored. The time development of the economy remains unnoticed. But its condition depends upon its history and its future partly depends on where people expect it to go. Opinions and efforts push in every direction so no one can foresee the result. Experts point this way and that. There are many prophets and Cassandras. Mathematical models only churn out nonsense.
Another big elephant is the non-rational consumer. She buys what she likes at the price she likes. Next week she’ll buy something because “it’s a bargain at twice the price.” Right. “I love it, I’ll take it, how much is it?” A free market supposedly doesn’t operate that way except when prices are rising, rising, rising. Remember houses in 2006? Willing buyers met willing sellers. All had perfect information about the market. None were forced to buy or sell. Demand for houses exceeded their supply but that didn’t matter. Buyers wanted to flip houses, sellers to take profits. Everyone could make money until the music stopped, as they all knew it would. Theory says that rising prices should create more housing but this was not about living space. It was a bubble. Houses did become bargains at twice the price. The same thing had happened with stocks in the 1920s and tulip bulbs in the 1630s.
Do people fail to calculate the best deal? Yes, all the time. Do free markets sometimes run wild instead of stabilizing themselves? Do economists realize this? Yes, and yes they do, but let’s not get too complicated with the models.
The neer-do-well cousin elephant, Dirty Money, has now become one the movers and shakers in international trade. He prefers, though, to stay out of the public eye because that’s the key to his success. Maybe up to half – half! – of all international transactions are involved with false, illegal or unreported wealth transfers using mis-priced invoices, tax havens, secret accounts, dummy corporations, hidden subsidiaries, etc. This tremendous amount of financial activity is used for many purposes, legal and illegal – holding profits offshore, transferring assets at desired prices, capital flight, hiding financial assets, money laundering, payoffs and kickbacks, drug running, arms sales, etc. Some of it is done by ordinary citizens and corporations, some by criminal enterprises and government agencies operating outside the law. A big reason that individuals use these hidden channels is to get rich and stay rich, secretly. Here’s a current money laundering scheme: straw buyers purchase nice homes and condos in Vancouver B.C. for millionaires in China at above market prices. The properties stay vacant. When later sold, maybe after appreciation, the proceeds are deposited in an American bank account, washed clean. An empty house can be kept as a bolt-hole when it’s time to get out of China. There are now too many such houses in Vancouver. Their number has risen so high that the mayor proposed a special property tax on abandoned homes. He says they are equivalent to blighted neighborhoods. Income tax evasion is relatively easy by comparison. Accumulating wealth overseas is the objective of these transactions.
Because international commercial flows of money have clean and dirty transactions all mixed together, their reported amounts and purposes can’t be taken at face value. The international payments system treats them alike. It can’t detect illegitimate ones, so we don’t know how to find their drag on the economy. Economists certainly don’t. So we’ll just ignore them since they can’t even be estimated, right? Perhaps under-the-table “fees” and differing amounts of corruption should be put into economic models as value-added taxes. Here’s a kind of tax even a conservative would love – it never gets into the hands of governments.
It’s easy to get excited about corruption on an individual level. It gets attention and indignation. A hundred thousand dollars is scandalous. The multiple millions that some rich people and government officials tuck away are political dynamite. Billions in dirty money are beyond imagination and invisible. The sewers of Paris in Victor Hugo’s Les Miserables were invaluable to those who knew them but were invisible to respectable citizens.
These three: private debt, non-rational consumers, and dirty money are the big elephants in the room which economists feel free to ignore when trying to predict what the economy will do.
Why are there financial panics? Why do they occur only after memories of the previous one have faded away? Why do sales of red dresses improve when Oprah Winfrey wears one on her TV show? How can unseen flows of money be understood when the hand is quicker than the eye? Perhaps economists really should give up on non-rational consumers, (there’s no accounting for tastes), and leave them to the psychologists. But international money flows are surely part of economics.
For a long time economists wouldn’t deal with credit and debt. As is common with shocking problems, the first stage in coping is Denial. It was thought that credit and debt could have no effect on the economy because loans and liabilities offset each other. One man’s debt was always another man’s asset. At the second stage came Recognition. Economists recognized that so-called debt instruments – pieces of paper that stood for loans, mortgages, bonds, and so forth – had lives of their own. They were bought and sold in financial markets while the debts they represented stayed attached to the debtors. Because the values of traded debt instruments changed with market conditions, bankers and financiers developed ways to evaluate them. They invented terms like Net Present Value, Declining Balance, Value at Risk, and others. These were continually changing but were, themselves, understood and predictable.
Economists as a group then entered the third stage, that of Confrontation. They knew about economic growth and the ups and downs of the business cycle, as they called it, and saw that both were connected with credit. They also saw that the sheer amount of credit dwarfed the money supply in our economy. Credit and debt had to be dealt with in economic theory but it was very hard to do. They were being created in huge amounts at every moment and then destroyed months or years later. In the interim, debt instruments were being separately bought and sold, fluctuating with interest and default rates, and moving all around the world. They were never in equilibrium. How could one model that situation?
A few special cases could be modeled. One was debt deflation. If the total amount of debt in society, so-called aggregate debt, grew to be colossally large and then someone, somewhere, couldn’t pay, a downward spiral could begin. Those who had over-borrowed might have to sell some assets which could start a wave of selling because many others were overleveraged too. Bankruptcies could spread widely with business failures, price reductions, layoffs, wage reductions and falling demand, all going down a steep and slippery slope. This self-perpetuating process had feedback going in the wrong direction. It could lead to a catastrophic depression. There was also an opposite model called a bubble – a buying craze – which could happen when the price of something rose steadily. Early buyers would make great profits. Others would pile in and buy, driving up demand, pushing prices higher, and they all would make fantastic profits.
A third special model was called “steady-state growth equilibrium.” Here it was assumed that all economic variables could change at exactly the proper rates to keep the overall economy growing at a constant rate. This was a very delicate balancing act. If population, prices, wages, profits, job creation, interest rates, inflation, business formation, technological change, imports and exports, investment and depreciation, money supply and credit creation would all move in proper balance with each other, and their rates of change were consistent and balanced on a knife-edge, it would be possible that the rate of growth of the entire economy would be constant as well. It is a strange kind of equilibrium where everything is growing. It fits an economist’s mind-set which sees any economy with stable and predictable variables as being in equilibrium.
A fresh view was introduced in 2008 by economist Hyman Minsky in his book Stabilizing an Unstable Economy. He proposed his ‘financial instability hypothesis’ outlining how the financial system tends to expand investment in good times, which gradually leading to overinvestment, then to more risky ventures, then to speculation, all ending in a crash. This process is similar to the normal business cycle where markets swing from boom to recession. Minsky’s contribution was to include the finance sector’s effect on the interplay between producers and consumers, showing that it amplified changes upward or downward. The booms and busts were bigger because of feedback from the financial sector. If a boom entered the speculative finance stage, which he called ponzi finance, the come-down would be severe – a crash not a recession.
Economics is now confusedly in a fourth stage: Rethinking. It is looking for a New Paradigm. This shift has been brewing for forty or more years, boiling up from below with dissatisfaction among younger economists and, surprisingly, neurologists who have been studying the brain’s response to economic situations. Neither accept the hypothesis of homo economicus as explanatory of human behavior. In 2000 the economics graduate students at the Paris École Normale Supérieure signed a manifesto that objected to the “autistic” economics they were being taught. [1] It read, in part:
“Too often the lectures leave no place for reflection. Out of all the approaches to economic questions that exist, generally only one is presented to us. This approach is supposed to explain everything by means of a purely axiomatic process, as if this were the economic truth. We do not accept this dogmatism.”
It created the so-called Post-Autistic Economics movement in Europe but it didn’t catch on in the U.S. A few sympathetic economists and journals became interested in so-called heterodox economics. This term includes behavioral economists who believe that the rational utility-maximizer is not even a useful fiction, and the econo-physicists who look at today’s economic models that are time-independent and say, “you’ve got to be kidding.” Another complaint of the heterodox economists is that the social hierarchy in the profession prevents new ideas from getting the hearing they deserve. Only orthodox papers done by mainstream economists get published in mainstream journals and, for now, it’s staying that way.
New attitudes are growing. A few academics are grappling with the fact that economic variables are not independent and are also time-dependent. Economic variables are neither causes nor effects; they are coupled together. Price, supply, demand, and behaviors spiral together, around and around, on the way up or down. The debt-deflation and bubble models are in this category. Other sciences have developed ways to handle feedback processes like these in order to describe reality as they found it. Economics have not recognized the need until recently. Partly it was because reliable data weren’t available – often there were no data at all. Controlled experiments couldn’t be done. And, it was so complicated. Even if all the interconnected equations could be written down it would be impossible to solve the tangled mess. So it had to be simplified; i.e., the economy was in equilibrium, people were rational; all of the rules above. They are not correct but maybe they will get us somewhere. They’ve became orthodox and are now well past their “use by” date.
I think that changes are slowly coming. Not with slap-the-forehead ‘eureka’ moments, but with recognition that our current small difficulties are not so small: “Houston, we’ve got a problem.”