Monday, March 09, 2009

The Harvard Mistake

Paul Samuelson, in a weekly syndicated column, has written about the mistakes Harvard economists Joseph Schumpeter and Edward Chamberlin made during the time the stock market crash of 1929 spread its spectre on the wider economy and eventually became known as the Great Depression, a decade-long slump which affected the western societies significantly. Samuelson goes on to argue that a similar mistake is being made by Harvard economists today, and he names Greg Mankiw and Robert Barro, when they oppose President Obama's plans to increase government investment as stimulus, including putting money in bad banks. Dr. Samuelson argues that Keynesian multiplier really works and one can see a multiplier effect of 1.5 projects results close to reality [what I understand of it is that every dollar spent by the government generates demand worth $1.50 in the economy] and therefore, the stimulus package is the only meanigful way to get the economy back on track. He argues that politics should not come on the way, and President Obama's package should have bipartisan support.

Elsewhere, other economists are pleading governments not to repeat the 'Japan' mistake - waiting for too long when the things are going bad. There is not much scope to wait too long indeed - every month is bringing bad news and it is hard to know how to reverse the decline. Banks are an obvious place to start, but now the disease has spread much beyond the banks and companies and individuals alike needs a 'stimulus' to keep going. Overall, the negative sentiments have become so widespread that investors are even pulling out of good projects midway and alternative capital is not being found. It is, as if, we are creating our way to a long term misery.

Interestingly, though, one argument against rushing into a bank bailout is that one does not know what the extent of the losses are and what exactly the taxpayers money will be used for. One can point a finger back at Paul Samuelson, who, in the 1970s, championed mathematical models and argued that all uncertainties could be modelled. This is precisely the point Amar Bhide makes in Businessweek: Samuelson's argument to move away from stock-picking and invest money in diversified portfolios could be seen to have encouraged banks from moving away from straightforward money-lending businesses and getting into riskier, complex derivatives. This is where bankers/economists tried to play God and create mathematical models which could estimate all uncertainties. This is what is failing now, as the domino effect of collective psychology plays out and one does not know what will go wrong when. This is exactly why banks are clueless about their portfolios and the government will be wary of putting money in something which they don't, and can't, know anything about. It is almost as if we have two economies - one mathematical-probabilistic and one real. We were supposed to create mathematical models around the reality, but as we progressed more, we modelled reality around mathematical model. And, when God played God, reality diverged from our models and we found ourselves in the middle of train wreck that we currently are.

It is also easy to see why Harvard economists keep making the same 'mistake'; because they see the pure economic side of the equation and think recession is a good thing. It indeed is: it unleashes the creative destruction and flushes out inefficiencies and wipes out economic rent accumulated in a long era of prosperity. It puts people back on the street and makes them hungry, innovative and competitive again. An artificial sedative in the form of a government stimulus, when this great waking up process is on, is counter-productive in that sense. However, they being Harvard economists, they don't necessarily see how painful this theoretical correction is for common men, small businesses and entrepreneurs. Social costs are not just social - they have as much economic import as any of those complex mathematical models have. They affect people's thinking for generations and shape economic policy of successive governments. Hence, this is modern economics' Slumdog moment, when they must step out of the boxes and see the real life models emerging with millions more variables than what their software can take.

Returning to Obama stimulus, his policy thinking is based on strange contradictions though. He is planning a stimulus on the faith that the rest of the world will continue to lend to the United States and be happy with the treasury bonds that they are given. The underlying assumption with which the rest of the world buys the treasury bonds is the hope that the American economy has enough resilience to withstand the downturn and come out with a new wave of innovative, entrepreneurial companies. At the same time, however, the President is trying a populist stance - playing 'dangerous politics', to borrow Samuelson's term - and inching towards a protected, almost closed, economy. So far, Obama has been harsh on immigration, harsh on outsourcing, harsh on getting qualified health care workers from abroad. All of this will undermine the competitiveness of the American businesses, both in the near and longer term. This may not give rest of the world continued confidence to innovate its way out of trouble, and this may mean a complete collapse of monetary and fiscal policy instruments in the United States, and by implication, in the rest of the world.

This doomsday scenario is possibly too far away, may even sound improbable. But all doomsday predictions are always like that. We live in an 'accelerated' world - no historical parallel can tell us about the trajectory our societies and countries are taking. Hence, while everyone today is keeping the balance, it will only take a small event - an insolvency of a big bank or company, a debt default of a leveraged country or even a natural disaster or an unanticipated war or unrest- to turn everything on its head. The China job fair looked like one such point, and I am sure we will be presented with one scenario a week, if not everyday, from now on.

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