Monday, October 24, 2011

Why intervention is necessary

SocialMacro has so far (1) indicated that the U.S. economy is performing well under its potential, (2) pointed to the fact of and a partial explanation for why personal consumption has failed to get the U.S. out of its depression, (3) what a liquidity trap is and why I believe the U.S. economy is currently in one, and (4) developed an argument for fiscal stimulus.  In one of my recent posts, I laid out what I believe to be common ground between myself and Professor Jeffrey Sachs.  Now lingering behind all of these issues is a large question, why is intervention in the market necessary?

The short answer is that there is clearly a market failure behind the current depression in the United States.  If there was nothing seriously wrong, there would not be such persistence (in other words, the economy would bounce back to full employment after an adjustment period or some tweaking of macroeconomic policy).  The core of the problem seems to be in a major decline in asset prices (homes and others) and an overhang of excessive debt. This is not such an unusual proximate cause to depressions.  The Great Depression seems to have been triggered by a massive collapse of asset prices (stock prices), the Lost Decade in Japan was preceded by a collapse of the housing market and the Asian economic crisis in the late 1990s was reportedly triggered by over-investment in commercial real estate in southeast Asia.  The main deal here is that not only was there wealth on one side (assets), but they were backed by large amounts of debt.  In the case of the Roaring 20's, much of the stock was bought on margin and many investment firms were leveraged up to the hilt.  Japan's housing market was backed by mortgages.  Much of the money in southeast Asian commercial real estate was borrowed in foreign currencies, making the problem far worse, since the collapse led to higher debt burdens in the local currencies.

The market failure in the United States was a large-scale misallocation of risk and debt.  The problem is that the best case scenario for a self-generated free-market recovery implies the continuation of the depression until the debt has worked itself down to much more manageable levels and for the asset markets to return to normal levels.  That means a lot of unemployment and a lot of pain for wage-earners.  Furthermore, there's no guarantee when things return to "normal" the U.S. will be proceeding along its former growth-path since much investment has been foregone because investing when there is huge excess capacity is a bad bet in the short- to medium-term.

Basically, the market failure is in the past, but its effects are still with us.  Ideally, means should be developed to prevent the crisis from repeating itself, thereby making this a one-off experience, but the problem here and now is still insufficient aggregate demand to ensure full employment.

1 comment:

  1. I believe you are right in your assessment.