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A recession/depression is the process of liquidating malinvestments and redeploying wealth and labor to economically profitable ventures.

If what you say were true, then we wouldn't be suffering from unemployment. We'd suffer from massive writedowns in our wealth (as we realize our malinvestments) but labor would be redeployed to new ventures. Effectively, we'd be working our assess off harder than before, but receiving a lower quality of life in return.

In reality, however, the economy is not at full employment. If we malinvested before (effectively did useless work), that should be a sunk cost. We wouldn't receive the future benefits we expected from that work, but that wouldn't preclude us from continuing to work. Malinvestment is not a reason for unemployment.

No, we're in a liquidity trap. Option A is monetary policy. That has been tried and exhausted. Option B is fiscal policy. Bring out the helicopters!

> If what you say were true, then we wouldn't be suffering from unemployment.

Uh, why not? I don't get it. Of course business liquidations and a decline in capital investments produces unemployment.

It's clear that the massive investments in housing over the last few years won't produce the returns we expected. Yes, we're going to suffer because those were bad investments.

But look at the bigger picture. We have productive economic resources (labor), why should they ever be sitting idle? It's not like we don't have problems to solve. We have to pay off our debt to the Chinese. We have to figure out what to do when the oil runs out. We have to make sure we don't destroy the planet sometime during the next century. We need to figure out how to take care of all the baby boomers once they retire. There's LOTS of work we need to be doing, but we're sitting around twiddling our thumbs. That makes no sense.

This presumes someone (the government? you?) can figure out what to do with that labor. Traditionally, in a capitalist economy, we let the market figure that out. Right now, the market's in a bit of a state.

Yes, in the industries where the bad investments where made (finance). But that alone cannot explain the withdrawing of investment from other industries.

You don't comprehend the macroeconomic scene if you think we're dealing with a "financial crisis." Dozens of sectors are at over capacity. Debt growth has hit its ceiling and households, governments, and businesses all over the country need to repair balance sheets. This is not about banks or financial firms.

No sectors exist in a vacuum. Take this very simplistic example:

The original source of our financial crisis is the collapse of subprime mortgages. People are getting kicked out of their homes, which has several effects:

- There are now a lot of houses on the market, driving prices down and reducing demand for more construction. Construction companies suffer, as do all of their labour and material suppliers (lumber companies, contract labour companies, etc)

- Banks have reacted to the defaults by attempting to protect themselves from further risk, meaning that it's harder than ever to get a mortgage. The effect is a similar drop in housing demand, with similar results as above.

- As the true scope of the problem unfolded, people began bailing on bank investments, driving prices down, and eliminating wealth that normal people have stored up in the form of mutual funds and such. This loss of wealth amongst "average people" has driven down consumer demand, and thus basically every other industry out there.

- As investors realized that consumer spending will be down, they withdraw their investments in these companies, resulting in further depression of the stock. This in turn causes more loss of wealth for people holding these investments, and causes a vicious cycle.

Nothing exists in a vacuum.

You have proved my point: that misinvestment alone is not the explanation. You also have to look for secondary effects from the financial collapse.

No, you're ignoring the fact that every time a desk company tools up a new factory, they are investing, and when those investments track a faulty projection on the demand for desks from financial services companies, they too have malinvested.

There's a much simpler explanation: the collapse of subprime mortgages forced people to confront the fact that there is way too much leverage in the economy. Too many people and companies owe money that they won't be able to pay back. The level of production of goods and services was based on the level of consumer and business spending, which everyone now realizes was being fueled by excessive debt. The level of production must now fall to a level that is consistent with businesses and consumers using much less debt going forward, and it will certainly overshoot on the downside because of panic and lack of information.

The question that I see being repeated in the media these days is "what are the banks doing with the bailout money, why aren't they lending it?" Perhaps the answer is that there is currently nobody out there who is a good enough credit risk to lend money to. Another possible answer is that the banks now realize that they've lost the ability to quantify credit risk correctly and they are going to need to relearn that skill.

> but labor would be redeployed to new ventures

Labor won't be deployed to new ventures when all of the companies that were involved in the malinvestment aren't allowed to fail.

Why not?

He means that if the companies aren't allowed to fail, they'll keep employing the labor that ought to be reallocated.

That's only true if they're continuing to make poor investments. All we know is that lots of companies made poor investments in the past. Letting them fail doesn't change that past, nor does bailing them out necessarily reduce the quality of future investments.

If the person I originally replied to is implying that the current bailouts create too much of a moral hazard, then that's a possibility, but that one sentence that was given doesn't do the issue justice.

"All we know is that lots of companies made poor investments in the past. Letting them fail doesn't change that past, ..."

Those poor investments will wipe out equity owners (and bond holders in many cases) when they are honestly documented on the balance sheet.

No rational person will make a new investment until after such honesty develops.

Have you seen the share prices lately for the companies that have needed the bailout? Citigroup's stock is down almost 95% since mid-2007. The equity holders have been wiped out. The poor investments don't need to be honestly documented for that to happen. If you know that poor investments have been made, so does the market.

What I mean by wiping out is that the company ceases to exist, its stock is deregistered, and a successor company is created by the bankruptcy receiver. Stockholders in most financial companies have not experienced this, because the government regulators have decided to prop the banks up as zombies.

Suppose a consortium of Arab investors decided to believe Citi's current published balance sheet, and bought $500M of newly-issued Citi common stock at US$2.00/share, a nice discount from its $3.40/share market price. They would most likely lose every penny of that investment when Citi fesses up to the true losses.

Of course the big money investors are no longer that foolish, having been burned several times by U.S. bank "recapitalization investments" in 2007/2008. Everybody is waiting on the sidelines for honesty to develop. This flight of capital has been billed as a liquidity crisis by the Wall Street hucksters, and used to justify mammoth bailouts, but in reality it is a solvency crisis and there is an ocean of hot money itching to be spent on honest companies.

we wouldn't be suffering from unemployment... labor would be redeployed to new ventures

Yes, but redeployment takes time -- especially when everyone looks around and sees all their assumptions about what profits different activities will return are wrong, and need to be recalibrated. That research -- which happens tentatively, experimentally at first -- means some capital/labor sits on the sidelines while the necessary information is collected or created.

Redeploying labor immediately at the first things you can think of might keep people busy but can worsen the wealth destruction, if those activities wind up being of net zero or negative benefit. (By tying up workers on make-work, they could also slow the rediscovery and restaffing of valuable projects.)

redeployment takes time

Those who have lost their jobs don't necessarily have the right skills for the more economically productive jobs that hopefully get created. Also, they don't necessarily live in the right places.

Not to mention that many who are in the right place and could profitably use new people are not sure of that fact, so they lack the confidence to bring in as many new people as they might otherwise.

Which is why fiscal stimulus is temporary. It's necessary while the economy is at less than full employment, but once the economy starts picking up fiscal stimulus should drop off.

That's the cover story. But how much of the $819 billion in the stimulus bill is set to automatically expire in 2 years, or when the economy reaches certain growth targets? Roughly: none. A lot of the spending won't even get flowing until 2010 or 2011, when the economy may be recovering just fine on its own.

But now you've left the argument about whether fiscal intervention is productive, and embarked instead on an argument about politics.

Theoretically, prompt fiscal intervention could temporarily fund productive projects for timely general economic benefit.

Practically, politics means fiscal intervention arrives late, stays too long, and is targeted to reward favored groups and centralize power.

There's no separating the two without a magic wand to implement benevolent stimulus without a political process.

Malinvestment also applies to labor. Workers need to retrain before they can start new productive jobs, and they need capital as well (not easy, since the US are borrowing instead of saving).

Depressions are what happens when Recessions start feeding off of their own fall. Looking back at the great depression the amount of knowledge did not change, the workforce did not change, the amount of natural resources did not change much, but things kept getting worse. Over the long term Recessions are useful but Depressions can cause a lot more harm than good.

PS: We are not in a depression, but a major goal should be to avoid a depression while we let this recession fix many of the problems your talking about.

The change in the depression was massive government intervention. Hoover reacted quickly with unprecedented price support programs and stimulus to preserve the status quo. FDR upped the ante, and kept doing it for many years. There was a depression because the mistakes of the 20s were not swiftly liquidated.

The policy prescription for the current crisis is to beef up food stamps and heating assistance programs so people don't starve or freeze, and then let all nonviable businesses fail as quickly as possible so they can be reconstituted as profitable companies.

That sounds like a great idea but are economy is based off of consumer spending which can just free fall.

"From 1929 to 1934, U.S. personal income plunged 44%, real output nosedived 30% and the unemployment rate soared to 25% of the American labor force." and the great depression still had 5 years left.

"By Jan 1, 1934, as many as half of all residential mortgages were delinquent" let alone all the ones that had already failed.

And it can fall far further in the next one. It's a house of cards and the bottom is far further than you might expect.

I don't understand how this is a response to anything I've said. Yes, consumer spending needs to plummet. Many thousands of retail businesses need to shut down. They are not viable. The profits in recent years were from phantom earnings: totally unsustainable and artificially credit growth, mounting consumer credit card debt and MEWs. The quicker we get the liquidation and write-downs over with the better.

Yes, consumer spending needs to plummet. Why?

We had a positive personal savings rate last month. Once you have a positive saving rate there is no long term problem with spending. (http://www.bea.gov/briefrm/saving.htm)

Now government spending is honorably out of whack, but that's not really related to what you're talking about. (http://www.frbsf.org/education/activities/drecon/answerxml.c...)

The general view amongst economists is that Hoover's price supports were the one thing that caused the depression. FDR implemented limited socialism, which did nothing to alleviate the depression-- there was not much he could do about it at that point --but was rather meant to keep people in homes, and clothed.

I agree that it is nonsense.

If hoarding leads to an irrationally priced money, rational people will quickly realize this and exchange their money for other alternatives that have become favorably priced.

Once this tipping point is reached, others will realize that they were overvaluing their money and the pendulum will swing back.

That's the Austrian view, anyway.

Check out this podcast. http://www.econtalk.org/archives/2009/01/roberts_and_han.htm... about different viewpoints in economics, and economists talking about how much they know and don't know.

http://www.econtalk.org/archives/2009/01/roberts_and_han.htm...

I find it strange that there still exist named schools of thought in economics; perhaps it's a sign of the field's intellectual immaturity. After all, which schools of thought are there in chemistry or physics? A few centuries ago you could have answered that question, but today it doesn't even make sense. I wonder if economics will ever reach the same level of development.

For what it's worth, the only economists who consistently avoid setting off my bullshit meter are the Austrians. And yet, their views border on lunatic fringe according to mainstream economists. In a world where those same economists set policy, that is an alarming combination.

aren't there some various schools of thought around string theory?

This concurrs with the grandfather's theory. This particular domain of physics, quantum theory, is certainly new and, we may say, as immature as the other domains were 3 centuries ago.

They exist in physics; see http://en.wikipedia.org/wiki/Interpretation_of_quantum_mecha...

Yes, but they don't differ on how you deal with practical problems, at least not ones on the level of how to design a car or a computer. Maybe they would affect cutting edge semiconductor research or fusion reactor design, (I don't think the interpretations of quantum physics do, but other conjectures might).

Interpretation of quantum mechanics is outside of the scope of physics, it's more like philosophy or something. For physics to be like economy in that respect, there would have to exist, for example, university professors who still wouldn't believe special relativity or quantum mechanics and claim that only the classical newtonian mechanics makes any sense.

I figured someone might mention this. (I almost addressed it in my original comment, but it was a bit peripheral to my main point.) The various quantum interpretations are not schools of physics thought; every physicist "believes" in quantum mechanics. They are schools of thought on the interpretation of quantum mechanics---which certainly is an indication of that (sub)field's intellectual immaturity. And, like economics, the interpretation of quantum mechanics has more than its share of bullshit. As Stephen Hawking supposedly once said, "When I hear of Schrödinger’s cat, I reach for my gun."

N.B. I predict the rise of quantum decoherence theory will change this picture in fairly short order.

I consider the silence of the Copenhagen interpretation over what happens during measurement to be an actual difference of physics, not of interpretation. If some other theory were able to predict, say, the time it takes for a wave function to collapse, or the number of particles another must interact with for it to decohere, or so on, it's a difference in predictive capacity, not merely of metaphysics.

That's a good point. There is definitely some physics content in the interpretation of quantum mechanics---Bell's Theorem certainly took many physicists by surprise when it came out, since it proved people were arguing over more than words---but in any case it's all a tiny higher order term in the series expansion for 'physics'. (The 0th order term is "Newton", FWIW. ;-)

Those tiny terms matter when things go nonlinear! ;-)

This post does a decent job explaining the phenomenon: http://unqualified-reservations.blogspot.com/2008/08/de-gust...

The core problem is that economics cannot use falsifiable experiments, and it is very highly politicized.

The core problem is that economics cannot use falsifiable experiments

I agree that falsifiable experiments are difficult in economics, which is why we must rely instead on logic and reason---a strategy seemingly abandoned by modern economists.

I remember the ridiculous (and since discredited) argument by Card & Krueger that increases in the minimum wage increased employment, at least according to their data. And yet, when you raise prices on normal goods, the quantity demanded falls; if you force companies to pay employees more, they will hire less. If the data say otherwise, the data are either wrong or too noisy to be trustworthy. (Unfortunately, their paper wasn't merely an academic curiosity---it gave Bill Clinton and Congress political cover to raise the minimum wage in 1996.)

And now we hear economists fret that Americans, who have been under-saving and over-spending for years, may yet ruin the economy---by saving too much and spending too little. Someone needs to tell them that wagging your finger and saying "liquidity trap" doesn't magically give the emperor clothes.

Thanks for introducing me to Unqualified Reservations, it's quite an interesting blog.

Some people are losing their jobs because they were in sectors that had too much malinvestment ( housing).

But many other are losing their jobs simply because of friction caused by the increase in demand for money. All contracts ( wage contracts and debt contracts) were written assuming an easier availability of money. When a deflation occurs, many businesses go bust not because they were "malinvestment" but simply because their contracts were denominated in 2007 dollars, not 2009 dollars. The correct response is to print money to prevent the deflation, thus removing the need for every business in the country to into bankruptcy court to get out of their debts.

Before the Great Depression, many people wanted cars and they could afford cars. After the great depression, the production of cars were even greater. Why did the factories need to stay idle during the great depression? Idle automobile factories were not a result of liquidating malinvestment, they were a result of collateral damage from deflation.

He needs to learn about inflation too ;-)