Free exchange

The wages of sin

On economic penance

MUST we pay for past sins? Michael Kinsley thinks so:

I don’t think suffering is good, but I do believe that we have to pay a price for past sins, and the longer we put it off, the higher the price will be. And future sufferers are not necessarily different people than the past and present sinners. That’s too easy.

But he isn't known for his economic bona fides. Matt Klein, who is, tries to put some meat on Mr Kinsley's argument, asking whether anyone could deny "that bad decisions often have unpleasant consequences". They must! If they didn't, they wouldn't be bad decisions. But what sort of consequences?

Between the beginning of 1996 and the middle of 2000, overly optimistic predictions about the potential for information technology fueled a surge in business spending: Real nonresidential private investment increased at an annualized rate of more than 12 percent. That wouldn't have been a problem if IT had lived up to the hype. Unfortunately, the investments weren't as worthwhile as advertised. Those capital expenditures saddled many businesses with unneeded capacity. Investment spending subsequently plunged by more than 20 percent and didn't return to its pre-recession level until the beginning of 2005.

As I noted in a previous post, the years following the tech bust were characterized by deeply depressed levels of private employment and stagnant median incomes. The irrational exuberance of the 1990s led directly to those unpleasant outcomes, despite the fact that the Federal Reserve was desperately trying to "boost asset prices in order to stimulate demand," as Donald Kohn put it in a meeting on March 16, 2004, and despite large tax cuts that raised the take-home incomes of many Americans. Reasonable people can disagree how we could have distributed the pain of the tech bust better. I struggle, however, to imagine a scenario in which no one suffered after all that waste.

Ok, let's work through this carefully. The argument, remember, is that "we must pay for past sins". As a first step, who is "we"? It would seem to be the folks whose overoptimistic predictions led them to make big IT investments. What was their sin? I think that would be making IT investments that ended up yielding much less in returns than anticipated. And how were they made to pay? Well, by reaping less than anticipated returns, of course!

Only, that's not the consequence Mr Klein identifies. Rather, he says that low post-crisis investment economy-wide was the cost, contributing to stagnant incomes and slow employment growth. But wait: those things affected everyone, including some people who probably thought the tech boom was ridiculous all along and who instead put their money into a "real economy" stock like Ford, and others who didn't invest at all but just worked as bookkeepers or hotel desk clerks. So what did those people do wrong that necessitated punishment? We no longer seem to be talking about payment for sins.

So let's strip the argument of its moral content and simply ask: must a financial gyration like the tech boom and bust cause economy-wide pain? Well, why would it?

One possiblity, which Mr Klein hints at, is that higher investment in one period begets lower investment in the next, as businesses are saddled with unneeded capacity. But if the problem is that firms were previously making lots of investments that didn't need to be made, then presumably they were neglecting other investments which did. The potential returns on those unmade investments should look pretty good, particularly given the fall in the cost of capital that came with the end of the boom. So that can't be it.

Maybe the servicing costs of the previous investment, on debt or the physical investments themselves, are constraining firms. But if the physical investments aren't paying off, then firms should simply stop maintaining them, no harm done. If dark fibre in the ground isn't making a company any money, then it will shift operating and maintenance funds on the dark fibre to something that is. What about debts? Well, if debt payments are constraining firms because they're keeping current, then that means lenders somewhere are earning some nice returns, despite the fact that the loan money was all blown on Superbowl ads. Or if the lenders are constrained because debtors are all defaulting, then that means the indebted firms have the money.

Ok, you say, but that's not how it actually works. Borrowing firms spend less, even after taking into consideration their debt payments, either because they got spooked by their losses or have suffered a reduction in credit-worthiness that prevents them from using credit as effectively post-crisis as they did pre-crisis. Lending firms fall into a similar dynamic. They may become excessively risk averse or face constraints raising funds. But these things shouldn't affect the available real return on projects elsewhere in the economy. And so unless all of the firms in the economy made big, bad IT bets, which seems unlikely, healthier enterprises should step into the vacuum left by sickly ones. And even if every firm was harmed in that way, the problem still comes down to the fact that there's not enough money to fund all deserving projects. But that's no problem! Central banks can make as much money as they want!

Hm. Maybe this will all be clearer if we consider a different example:

From the beginning of 2002 through the middle of 2005, real residential construction spending grew at an annualized rate of 7.4 percent. That compares to a long-term average growth rate of just 1.9 percent. Even excluding the data since the end of 2000, the long-term average growth rate in real residential construction spending is still only 3.1 percent. Remember that this average includes the years when houses were being built in record numbers to accommodate the postwar "baby boom." Easy credit boosted housing prices, which in turn financed about $1.25 trillion in additional consumer spending.

We are still living with the consequences of the excessive private borrowing of the go-go years: joblessness, poverty, and falling real incomes for middle-class Americans.

Surely we can agree that there are too many houses in America, right? Well maybe, if a house is a house is a house. But what if a house in one location isn't the same as a house in another? And what if various economic trends were motivating internal migration? In that case, you could still justify high levels of residential investment even though overall population wasn't growing (in the same way that people still build new manufacturing facilities despite the fact that America built a tonne of factories back in the day when a much larger share of the population worked in industry). But even if America built way too many homes in every location in the 2000s, we find ourselves back at the dark fibre juncture; if a new house is empty you can always just let it rot and use the money to invest in worthy projects that were neglected during the earlier boom.

Ok, but there's definitely an issue with the fall in housing prices, right? No, not really. Falling home prices are great news for everyone who didn't own a house; their real incomes soar as a result. What if they don't soar by enough to make up for lost consumption, or what if battered banks don't want to lend, or what if defaulting homeowners can't get loans, etc.? These are all versions of there's-not-enough-money argument. And if there's not enough money, then more money can be made.

All right, all right, but here's something that really might be an issue. Maybe we can agree that too much investment of one sort in one period simply makes investment of different sorts more attractive in the next. But what if during that first period everyone went out and accumulated lots of human capital specifically oriented around that first-period-sort of investment? And then in the second period they didn't have the right kind of human capital! What if everyone learned to write html and then suddenly no one wanted to build websites? Couldn't that be a problem? No, not really, not unless the act of learning one thing makes a person physically unable to learn something else. If too many people invested in the wrong sort of education in the first period, then that should raise the return to investing in the right sort in the second. Just like with houses and fibre.

Ok, if you're thinking that all of the above is a little glib, you're right. There are certainly ways that a financial mania could impair future growth potential. If the people getting the wrong kind of skills were a particularly large demographic cohort in their prime working years, then retraining might nonetheless leave the economy unable to grow as rapidly as it otherwise would have. Immigration could make up the difference, perhaps, but then one has to wonder why there wasn't an optimal level of immigration in the first place and at any rate the point is that it's possible to exhaust a structurally important finite resource during one of these episodes. It is far from clear that America did, however. Had the dot come boom entailed the burning of all the world's coal or a misguided scheme to profit by salting the earth's arable land, that would have been problematic, but it didn't.

We can absolutely imagine other ways that economies would fall short after a crash. Maybe government interventions during the bust altered incentives, encouraging firms to invest in suboptimal ways or rent-seek. Maybe the boom and bust led to massive redistribution of wealth—to a political elite, perhaps, that is then able to enact growth-killing policy, or to a subsegment of the population constitutionally disposed to cash-hoarding. Maybe policy makers don't know enough about economics to understand that simply creating more money or redistributing existing money would solve the problem. Maybe humans have an inevitable weakness for moralistic arguments and easily fall prey to the view that economic pain is divine justice and shouldn't be assuaged. Maybe humanity hasn't yet evolved political systems robust enough to reliably enact the appropriate policies in a timely fashion.

We can find elements of all of those difficulties and others at work after crashes. And history clearly shows that whether necessary or not, financial meltdowns do tend to cause serious economic pain, for the "sinners" and innocent alike. But it's important to point out that these consequences don't flow inevitably from poor past investment choices. Past "excess" doesn't somehow break an economy; it just confuses the people who run it regarding what is supposed to come next.

That might strike some as effective acknowledgement that booms necessarily require penance. If the only way to avoid a painful bust is to employ policy-makers who know just what to do in just the right circumstances, then there is no avoiding a painful bust. But there is an important difference. We, rather than some divine agent of economic karma or physical economic law, are the ones causing the pain. And just because we don't know any better now doesn't mean we'll never learn. Once upon a time humans burned heretics at the stake. Much more recently, they thought that raising interest rates to protect an international gold standard was a useful approach to global depression. The beauty of bad ideas is that they can be replaced by good ones. And so I dream of a day when the only people who suffer from money-losing investments are the money-losing investors, whose only penance is lost money.

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