Cap'n Transit on the Economy

One of our frequent readers, Cap'n Transit, wrote last month on his blog (Cap'n Transit Rides Again) about the difficulty in solving the short, medium and long-term problems of the economy, as well as the difficult challenge of knowing the difference. It was a very thoughtful piece and I have a passion for engaging intellectually with anyone who is coherent on this topic. Cap'n Transit has raised some good points and I wanted to take a little bit of time to go over them.

Here is the meat of the post from August 20:

Yes, it's true that we're facing the peak oil crisis and the climate change crisis, and Marohn is quite right that we have an additional crisis of overbuilt infrastructure that we don't have the financial ability to maintain. We may not even have the "real" ability to maintain it, in terms of resources like manpower, asphalt and energy, while still feeding ourselves and producing goods for export.

The fact is that those are all three long term problems. There are similar-looking short-term problems, but the solution to a short-term problem is not always the same as the first step of solving a similar long-term problem. For example, if it's cold in my apartment one day, I may want to turn on a space heater. If it's cold in my apartment all winter, I may want to replace my weatherstripping. The first step to replacing weatherstripping is to see if the hardware store is open, but that won't make my apartment any warmer in the short term. I may want to turn on the space heater and see if the hardware store is open. It may be a bit wasteful to run the space heater with leaky windows, but for a day it's not that big a deal.

This is what I think Marohn and Kunstler are missing when it comes to Paul Krugman, Matt Yglesias and their calls for Keynesian stimulus. Marohn and Kunstler criticize Krugman for not realizing the severity of the situation. Krugman may or may not realize the severity of the situation, but he knows that the economy has the short-term capacity to put most people back to work and bring tax revenues back up, if the government were willing to tolerate some inflation.

Let me point out the obvious first. If Paul Krugman and I are in a room together, only one of us has a Nobel Prize in Economics (hint: it's not me). That having been said, in the spirit of the blogosphere where everyone can pretend to debate a Nobel laureate, I will take issue with the Krugman advocacy of Keynesian stimulus, but try to juxtapose his views with those of other economic thinkers I enjoy.

Let's examine the cold apartment analogy presented by Cap'n Transit. (And by the way....I kind of enjoy writing the name Cap'n Transit. It has a super hero quality to it. Very cool.) The weatherstripping is bad and so the apartment is cold. We can't fix the weather stripping today, so we take some other short-term action instead, then fix the weather stripping tomorrow.

I agree that this is very logical. And certainly this is how I would handle that problem. But that is not how we as a society collectively act, or have collectively acted for decades. Society would turn up the space heater, get rid of the cold and then forget it was cold in the first place. Pretty soon we would have a space heater entitlement and it would be every elected official's duty to ensure that it was kept running. Whole space heater industries would spring up, complete with a massive lobby, to advocate for the continuation of solving this temperature problem with space heaters. Weather stripping would now threaten their jobs and, over time, the entire economy, so we would develop a weather stripping tax. A narrative would develop that it was space heaters that kept us warm all these years, that the poor, the children and the elderly would be hurt worst if there was a change in space heater policy.

As modestly uncomfortable as it would have been at the time, I'd rather society just spent one chilly night and then went out and took care of the problem itself the next day.

I believe that Paul Krugman is right, as is Robert Reich, in arguing that we could end this great recession with more stimulus. We could create jobs, etc. by spending more money. If we had no limit to what we could spend, we could create full employment.

As I wrote earlier this year after reading the book When Money Dies by Adam Fergussen, this is what Weimar Germany did in the 1930's 1920's. They couldn't decide between dealing with deflation or unemployment -- they had a political stalemate -- and the default setting was to print money and deficit spend (sound familiar). That is, until hyperinflation took over and they had no currency and no employment.

The problem with Krugman's approach, and modern Keynesianism in general, is that it looks at recessions as bad. I wrote about this last year in a piece, Only you can prevent financial fires (September 27, 2010) and used the analogy of a forest fire. In the 1950's and 1960's, we had a mentality that we could suppress the cycles of nature by suppressing forest fires as soon as they broke out. This had two devastating impacts. First, it built up what we now understand is an explosive amount of fuel within the forest (bad investment that should have been purged, in an economic sense, and now too-big-to-fail). Second, it encouraged people to disregard the impact of forest fires in choosing where to live (in financial terms, this is called moral hazard). As Jared Diamonds pointed out in his book, Collapse, this will not end well.

Recessions are not bad. Recessions are good. The key is that they should be minor and frequent. This is an embrace of the "break early" concept as opposed to the "too-big-to-fail" approach we have gotten ourselves into. Once you go so far down that Keynesian road, recessions are no longer the necessary pruning of the forest stand. They've been quashed until they become destructive, out-of-control, raging conflagrations. Welcome to 2011.

My favorite way to explain this is the circus and restaurant analogy used by Peter Schiff in his prescient speech to the Mortgage Bankers Association two years prior to the housing collapse. (Seriously that speech is a must watch). You own a restaurant. A circus comes to town. All of a sudden there are all these new people eating at the restaurant. You don't know it is from a circus, you misread the demand and decide to expand your restaurant. The circus leaves town and all of a sudden you are in a recession. You need to contract and rid yourself of this malinvestment. Schiff delivers this analogy at time marker 12:20.

In a Keynes/Krugman world, the problem is not the malinvestment but the lack of demand. The solution is for the government to intervene, prop up demand and keep the restaurant from having to contract. The hope is that at some point the market will grow and create the demand itself without the need for fiscal support.

The key for a healthy economy is to learn from your mistakes early. You want the ma and pa restaurant with the malinvestment to fail before it grows into a multinational chain. You want the mismanaged local bank to fail before it grows into Bank of America. You want the housing and tech bubbles -- both the product of artificial Fed stimulus -- to never happen. We purge these malinvestments early, or avoid them altogether, and the pain is much less. Lower stakes and more manageable.

This is the world envisioned by Nassim Taleb, my favorite economic thinker and perhaps the Patron Saint of Strong Towns thinking. He advocates for financial systems that are resilient, that can overcome human error. As we have pointed out numerous times this year (Our unfaithful partner / Downgraded), prolonged deficit spending creates tremendous reliance on forecasts of economic growth. Mess up the forecast (we're human, so we will) and the entire thing stops working. We need to create our systems to operate more like natural systems; resilient and adaptable.

This brings me to my central problem with Keynes, Krugman and really all things involving big hubris (I include national political parties here). While I will freely admit that Krugman is more intelligent than I am, I'll also point out that he knows only a tiny fraction of the knowledge amassed by humanity, which itself is but a tiny fraction of what is to be known in this universe. I'm very wary of economists who have the hubris to believe that they know THE solution, that somehow they have mastered this massively complicated, intertwined and ever-changing system of economics we have developed. Greenspan claimed to have ended the business cycle. Oops. I'm not willing to bet more and more of our future that Bernanke is any more prescient.

If we follow columnist Matt Miller's -- always the centrist -- advice, we would stimulate now and apply austerity later when the economy is growing again. That assumes that (1) the economy can actually grow and (2) we will have the discipline to be austere later. I like Matt Miller, but on the latter assumption I'll point out that we were profligate in the best times and profligate in the worst times. It's never a good time for austerity. On the former, I believe that without dramatic reform of our underlying development pattern, there will be no sustained growth.

I would argue that our economy departed from reality a long time ago. There is little question that the dollar has gone on its own trajectory since we left the gold standard in the 1970's. The tech bubble was not real and neither was the housing bubble that was brought about to solve the tech bubble. So go back to whatever point you like as your baseline: 1950, 1970, 1995 or 2002. Much of what we experienced since then was a growth illusion, so that is where we need to get back to before we can have real growth. At this point, there are very painful ways to do that and there are devastatingly painful ways to do that. Throw in the new reality of peak everything and I find this all to be a sad, sad tragedy.

My basic argument with Krugman et. al. is that they seem to deny the need for a reset. It is inevitable.

Thanks to Cap'n Transit for his post. I hope he follows this up on his blog and we can continue this conversation. Unlike Krugman, I know I'm wrong. Feel free to tell me where. I should also point out that, while I chat frequently with the others here at Strong Towns, the detailed nature of this post means that it likely veers from Jon and Ben's opinion on these matters. For the sake of discussion, assume they agree with you on whatever you disagree with me on.