Limbo, the Maytag Repairman, and Macro Markets

How low can you go? Sometimes when spending seems weak and prices are falling there seems to be no end to that cycle. It’s like we are staring down into a bottomless pit. It seems like there is no end to the fall in prices. But prices never fall without limit and the real world is a little more like the limbo than a bottomless hole in the ground. 

You remember the limbo, right? It is a calypso thing. Two people hold the ends of a long stick and some fool with especially rubbery legs goes under the bar as people sing limbo limbo limbo like me while they drink tall island drinks with colorful parasols. As the bar goes lower some of the contestants no longer can go under the bar and the game ends when there is only one contestant who can go under the bar. For his efforts he is usually awarded discount coupons for orthopedic surgery. Or the game ends when your mom comes home and confiscates the rum you stole from her liquor cabinet.

The point of this post is to raise the question of the relative efficacy of market solutions to government intervention.  After five years we might want to question knee-jerk Keynesianism. To do this we have to take a little venture down supply and demand lane. We will now all hold hands and sing gumbaya.

For those who do not want a refresher in supply and demand you may cheerfully proceed down to the place marked “The Fun Starts Here.”

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Economists torture their students with supply and demand to discuss everything from wart growth to interplanetary travel. We can slap a S&D diagram on a white board or cocktail napkin quicker than you can say diminishing marginal returns. My friend Jimmy can wield a small hammer at limestone and produce a beautiful wall or walkway. My hammer is my set of colored markers that I can use to explain price and quantity changes of anything anywhere at any time.

The invention of the stirrup revolutionized warfare and led to a rapid increase in the price of saddles and horses.  Centuries later technological advances in computer chips led to astronomical declines in the price per unit of power for computers. The stirrup increased the usefulness and therefore the demand for horses and saddles and this caused their prices to rise. Computer chip technology made it possible to increase the supply of power at lower costs which led to declines in the price of computer power.

Supply and demand analysis has found its way into common discussion. Most of us are comfortable with the idea that bad weather which ruins crop yields will reduce supply and causes the price of tomatoes to rise. Of course when worry reduces investor appetite for risk we talk about how the decline in the demand for stocks causes stock prices to fall. You don’t have to be an economist to be familiar with the use of supply and demand concepts and how they come together to help one discuss past, present, or future expected price change. I am not trying to say that supply and demand is as well-known as a Charlie Sheen rant, but we have adopted this economic analysis tool to our everyday lives.

Supply and demand analysis is a pretty remarkable thing that comes up with predictions by making assumptions. For example, one assumption says that prices will change in response to the condition of a market. If the main change in a market is an increase in demand, for example, then in the absence of price change or before a price change can take place – this creates an imbalance in the market. In this example, we would observe demand greater than supply. This imbalance or shortage creates the incentives for both demanders and suppliers to agree to a higher price.  In the opposite case which finds supply much larger than demand, this surplus leads market participants to agree to a lower price.  When the price changes in response to these market imbalances, we say that the price change “clears the market.” Clearing of the market means that the price change brings supply and demand back towards equality. A conclusion of the usual market model is that prices play an important role of restoring balance to markets.

Adam Smith’s “invisible hand” concept explained that if markets were allowed to work then we would not need policy or policymakers or baboons to solve market imbalances. If there is too little or too much demand for a given supply you don’t need a committee of experts to solve the problem. What you need is a market wherein there is strong competition, good information, no impediments preventing actors from expressing market wishes, and no obstacles to prices changing as the market dictates.

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The Fun Starts Here

Those last paragraphs sound like a textbook and even I am getting sleepy. But a big point is that whether it is stirrups, tomatoes or whatever – we tend to adopt supply and demand analysis and use it to explain and predict real world outcomes.

This is why I am so perplexed about our application of these tools to macroeconomic situations.  While it might seem a bit far-fetched to some of you, macroeconomists apply supply and demand to a nation’s economy. Macroeconomists since J.M. Keynes have adopted the idea of national demand for goods and services and policy is often directed to stabilizing undesirable changes in aggregate demand. Accordingly, some macroeconomists believe that part of the solution to our latest recession is downward price adjustments. Since much of what caused the recession was a decrease in the demand for houses and financial assets, an application of supply and demand would argue that falling prices of houses and financial assets should part of the solution to market balance or equilibrium. At the macro level it is interesting that our policymakers were not content to just let Adam Smith’s invisible hand solve the problem. Rather than believe there was some reasonable end to a game of Macro-Limbo, they worried that prices were headed into a dark pit filled with rattle snakes and Rush Limbaugh. To prevent prices of financial, housing, and other assets from declining to the earth’s core, the Fed and the Treasury bought stocks, bonds, and companies like geeks at the introduction of the latest gadget at the Apple Store. To prevent housing prices from falling toward the South Pole the government not only bought houses but put in a whole new team to regulate foreclosures and to oversee an orderly disposition of houses.

Distrusting prices to equilibrate these markets, policymakers essentially stopped the markets from working and it appears in the end that they have drastically slowed the movement towards a new balance. Why did policymakers behave this way?  Why did they not allow market capitalism to function? One can only guess the reasons. One is that while they trusted markets to work for most things on most days, they lost their trust when it came to bigger events. Imagine if doctors decided not to use modern medicine every time they had to treat a really serious ailment! Second, what fun is it being in charge of a country if you don’t do anything but stand around watching prices fall and don’t get any credit when the problem disappears? Let’s call that the Maytag Repairman explanation. Third, perhaps they worried that prices would not move in the right direction. But of course, housing, bond, and stock prices did move in predictable fashion. Fourth, perhaps they worried that prices would fall too much and create too much havoc as they fell. It seems to me that this explains a lot of the mistrust of markets. When policymakers faced the public with sad worried eyes they proclaimed that it was necessary for government programs to forestall a horrible process.

Some policy makers are bragging about recent stock prices but notice that with all the merriment, the stock indexes are now only regaining a peak reached during the recession and still have a long way to go before reaching highs attained before the crisis. It has been half a decade of no real stock price growth. But with housing prices still falling, one has to wonder if the real truth of the intervention is that it simply stretched out the eventual adjustment. Prices were going to fall to clear the market but the government made sure the price change took years and years and years.

Geithner and Bernanke would say that I am a nut job. Letting the economy free fall would surely have caused a larger crash. But while most of my friends will agree that I am surely a nut job, I will not agree to what we can’t know. How far would prices have fallen and what would have been the side effects?  I suspect that without government’s mucking up expectations, prices of houses would have overshot in a downward direction and would have made housing the bargain of the century. After all – a house has real worth. It is composed of brick and mortar and sweat. That has value. If we overbuilt houses for numerous years the glut would lead to prices at the low end of that fundamental value. But clearly demand plays a role – and with housing prices cheap enough relative to the cost of producing new houses – the demand could come back. But we never let the prices reach those levels and we will never know how the invisible hand might have worked.

Let’s suppose housing or stock prices fell to these low values I proclaim above, wouldn’t that have killed off a lot of mortgages and created a national recession? Probably. But what I am raising here is that we chose to pull the band aid off slowly. Are we sure that the accumulated pain of the last five years of heavily regulated markets is not greater than the quicker and perhaps more intense spike of pain associated with a quick pull of the bandage? The unemployment rate has been high for quite a while and threatens to remain there for some time. Might these unemployed have been better off if that rate had risen even higher in 2008 or 2009 but was back to 6% today? What I do know is that it is now March of 2012 and we still hear our leaders proclaim that they saved the day and that without further stimulus the economy will go back into recession. I am not so sure that a market solution could have been much worse. The recession started in the beginning of 2007 and ended in the middle of 2009. Five years after the recession started and after trillions of dollars of very active policy, US policymakers admit that the economy is still too weak to be trusted. I think it is the policymakers that can no longer be trusted.