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"This is Why We Do Statistics..."

Monday, March 16, 2015 we don't have to explain why reality doesn't match our theories...

Business Insider interviewed Paul Krugman on the two 'schools' in economics.  Krugman calls them the 'fresh water' and 'salt water' schools.  Historically, they have been known as the Keynesian school (after John Maynard Keynes) and Austrian school (generally referring to Ludwig von Mises). Another way this divide has been defined is between 'supply side' (Austrian school) and 'demand side' (Keynesian school).

"Ugggh... It's morning and I just started on my coffee!"

Yes, yes, dear reader... I have mine right next to me as well.  But when the 'demand side' school (Krugman and his Keynesian companions) finally run up against the wall that is zero, the consequences are going to be severe.  If you are my age, you might want to think twice before remodeling Junior's room; he might very well need it again (if he isn't back at home already mired in student loan debt).

That student loan debt is a perfect example of the end result of Keynesian economics.  The idea is that by pushing money into the economy, we stimulate demand (thus the term 'stimulus').  It's a nice theory, and Krugman and his Keynesian pals are very fond of observing their theories through their statistical looking glass.* But reality?

Consider: Banks borrow money from the Federal Reserve essentially for free.  Because of the computer, the Treasury does not have to actually print these dollars.  But this expansion of credit is 'money printing' just the same.  The banks then take those free dollars and lend them out at around six percent.  That alone is a really nice deal for the banks.  But it is even better when you consider that these student loans are essentially co-signed by the taxpayer (you and me).  And it gets even better still (for the banks): unlike all other kinds of debt, you cannot escape them in bankruptcy.  If there ever was an 'Exhibit A' for crony capitalism, this is it.

What this does is remove all incentives on the banking side to actually lend responsibly.  Let me draw an analogy to explain:  We recently replaced our 15 year old minivan.  Our credit union pre-approved us for a certain amount and mailed me a 'draft'.  But I could not just make that draft out to myself and deposit it in my bank account.  I had to make it out to the dealer in a certain way.  The dealer then had to call in to the credit union for a code and submit the paperwork proving I took delivery of the vehicle.  Only then could they submit the draft for payment.

Why do this?  Because that car loan can be escaped in a bankruptcy.  We'd lose the car, for sure, but the credit union would lose a significant amount of money to depreciation.  The credit union structures the use of the money like this to ensure it is used for its proper purpose.  At least then they know they have a car to repossess were we to stop making the payments.

Not so with student loans.  The banks are basically throwing money at our kids.  There are no controls to prevent young people from using student loan money for things like rent, utilities and groceries.  And so today our young people are saddled with about $1.2T (no, not million, not billion - TRILLION) of outstanding student loans.  And this inflation of the money supply in higher education - championed by people like Krugman- directly results in tuition inflation.

It is very easy to fault the students.  But remember the golden rule: The guy with the gold makes the rules.  Human nature being what it is, responsible borrowing simply has to begin with responsible lending.  And responsible lending is directly tied to risk.  If there is no risk, there eventually will be no responsibility.  It is all but impossible to imagine how people like Krugman can miss this lesson from not only the last financial crisis, but from every one that has come before it.

But back to the wall that is zero.  Keynesian 'demand-side' economics says that by increasing the money supply (which is partly done by lowering interest rates), demand is stimulated and creates economic growth.  Reality, though (shown by things like income inequality), shows that the resulting increase in demand is primarily 'sunk' into real estate and the stock market.  And so the rich get richer and everyone else's dollars buy them less and less.  Or to be more succinct: Demand-side economics does not deliver on its promises regardless of how things look through the statistical looking glass.*

And when interest rates begin to bump up against the wall that is zero, an interesting dynamic begins to take hold.  This is already being seen in Europe, where the European Central Bank actually charges European banks to hold on to their reserves - those reserves 'earn' negative interest rates.

The logic of this should be quite easy to grasp: What will you do when your bank starts setting negative interest rates in addition to those monthly fees they charge?  You're better off just pulling the money out and sticking it in a safe.  The whole idea of money - and the banking system with it - stops making any sense (except maybe is it is seen through the looking glass*).  If we get to that point, bank on it: Junior will come knocking and need his room back.

The other thing this does - and this is quite a bit more subtle - is introduce the 'deflation' dynamic into lending.  To keep it simple: If rates are at zero, they cannot go down any further for any significant period of time - again, the whole idea of money and banking (and all of the cherished Keynesian economic theories with it) will eventually collapse.  So they have to go up.  Why lend your reserves today at, say, one-two percent when you know those rates have to go up soon?

The 'deflation' dynamic is this: When you think prices are going to go down, you hold on to your money.  That lessens demand, which puts even stronger downward pressure on prices, only strengthening your incentive to hold on to your money, which lessens demand even further, strengthening your incentive to hold on to your money.... and 'round and 'round we go; where we stop, nobody knows.

In lending, interest rates are bench-marked to the 'price' of the 10 year U.S. Treasury Bond.  As that price get higher, the interest rate (or 'yield') gets lower.  Because interest rates are so low right now, bond prices are high.  Why buy a bond (i.e. lend money) at a high price today when you know you will be able to buy that bond at a lower price tomorrow?  You hold on to your money, and 'round and 'round we go...

This is the mathematical reality of the wall that is zero.  Krugman and his Keynesian pals want to prattle along in their dens and classrooms looking at the world through the statistical looking glass* of their theories.  It would actually be funny if the consequences for our kids and grand kids weren't so grave.

* It occurs to me that my younger reader may not get the 'looking glass' reference.  Google 'Alice in Wonderland' for more info...


  1. "This is the mathematical reality of the wall that is zero. Krugman and his Keynesian pals want to prattle along in their dens and classrooms looking at the world through the statistical looking glass* of their theories. It would actually be funny if the consequences for our kids and grand kids weren't so grave."

    Have you actually read what Krugman has written about this? He's made likely dozens of posts by now on the zero lower bound. You should look them up, I believe you're operating under several misunderstandings of what Krugman is actually arguing.

    1. If you are charging toward a wall, common sense would suggest that your writing about would be limited to one word: STOP!

      But no, Krugman has posted numerous times about the 'zero boundary'. Only his answer seems to be taxes. So we make transactions in the economy more expensive and then expect to see more of them? Please, will the Nobel Laureate explain how that works in the real world?

      No, sorry, in the real world where real things are produces and real businesses have to set prices - and account for taxes in the process - in order to make payroll and acquire the next batch of raw materials, making the sale more expensive does not result in more sales. It results in less, which then works its way into less revenue to assuage the "conscience of a liberal."

      And so the Keynesian answer has to be more credit, which makes money ever cheaper. Krugman can write all he wants about the zero boundary... and keep the train chugging right along toward that wall... or cliff as the case may be.

      Again, you do not need a Nobel Prize to understand that writing sensibly about this demands one single word.



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