Conversation Interruptus: Martin Wolf vs. The Daily Capitalist

By Jeff Harding

I am an avid reader of Martin Wolf’s columns in the Financial Times. I disagree with him quite a bit, but I find him to be perceptive, bright, and one who can think on his own. As you may know, Wolf is the Chief Economics writer for the FT, and is rather famous and renowned in the world of financial reporting and commentary.

I first corresponded with him on an article he wrote that claimed rising bond rates showed that inflation was here and that indicated we were in recovery. My message about that starts with No. 1 and our discussion goes on until No. 7.

Starting with No. 8, I had read his column on how to fix the banks, “The cautious approach to fixing banks will not work,” published online on June 30, 2009. The article’s blurb states:

The financial system had to be rescued from its own mismanagement of risk. This is not going to be changed by external supervision, which would be like moving the regulatory deckchairs on the deck of the Titanic. It is going to be changed only by fixing incentives.

He had some great ideas, but I was disappointed in that he didn’t address some of the more fundamental issues, including the government’s role in ruining the banks. We continue from there.

I think you will enjoy this discussion. Consider it to be the antidote to my conversations in “The State of Economics Education in America.”

He has promised a response to my rejoinder, No. 12, but it hasn’t arrived yet, although I have reminded him of it.

I am flattered that he would be willing to talk economics with me. I would guess he likes disputation to hone his thinking, as do I.

These conversations all took place in July, 2009.

1

Dear Mr. Wolf:

I finally got a chance to read your column on how rising bond rates show that govt policies are working. I am rather surprised by your and Krugman’s conclusions and couldn’t agree more with Taylor and Ferguson. Could it be possible that inflation expectations are driving demand for Tips vs unprotected Treasuries?

Jeff Harding

2

Dear Mr. Harding:

It’s possible – it was the thesis of my piece after all that inflation expectations are normalising. But I don’t think there is any credible account of the impact of excessive deficits now that would not include rising real interest rates.

Since you don’t cite any evidence for your views, I can’t really comment.

Martin Wolf

3

Dear Mr. Wolf:

I’ve re-read your article as well as Paul Krugman’s article on “The Big Inflation Scare.” I’ve been reading both of you for a while and I enjoy your commentary, but I don’t think Krugman is very credible. I should say that I am definitely not Keynesian, but Austrian (yes, that crackpot, but very accurate, branch of economics).

I think your comment on TIPs is entirely correct at present and that my assumption is wrong. While volume in TIPs has been increasing, I can’t say that its enough to reduce the spread. My take is that the bond market is wrong at this point and we are still facing deflation. Like most people, traders believe in the government’s ability to cure the markets.

Looking back at Niall Ferguson’s comments in the latest debate, I will say that good theoreticians are often wrong on market predictions, so I won’t hold that against him. On the other hand George Soros knows how to make money but I don’t he think he has a good grasp of any theory. But …

1. The bond market is normalizing, but I think this is wrong because I see more deflation ahead: housing, commercial real estate, liquidation of the big subprime trusts, securitized credit card and auto debt, declining wages, and so on and on. I think you are jumping the gun.

2. Crowding out hasn’t occurred yet, but it will. While corporate bonds spreads have narrowed, its a fake move. Ferguson is absolutely correct: when the $2 trillion is financed between now and September it will impact interest rates.

3. I understand you believe in Keynesian fiscal stimulus, but you have no basis to conclude it works. In fact, please tell me when it has ever worked? Never? The problem with the economy is not reduced consumption, as Krugman puts it, but too much debt, which is why we continue to deleverage (and consumer credit continues to contract). I’m not going to argue theory here, but everything Krugman recommended to the Japanese was tried in some fashion and never worked. Please don’t use his excuse that they didn’t do enough, soon enough. Krugman also has no basis to state that the rising level of savings will sop up treasuries.

4. When the deflationary period bottoms out, loan demand will revive and then there will be no way out of inflation as the money expansion hits the economy. Since Bernanke-Geithner-Summers all believe that rising interest rates will destroy the economy, how can they withdraw the massive credit expansion? They can’t.

Lets wait until about September to see who’s right.

I write an economics blog, and one of my recent posts was specifically on Krugman’s inflation nonsense. I write from an Austrian perspective and its quite a different look at the world: The Daily Capitalist.

I look forward to reading your columns in the future.

Jeff Harding

4

Dear Mr. Harding:

Keynesian stimulus did fine in the Second World War in both the US and UK.

I presume you are in favour of raising taxes and cutting spending right now, on an enormous scale. I think that would be a pretty crazy thing to do.

I know the Austrian approach to macroeconomics. I just don’t agree with it.

Martin Wolf

5

Dear Mr. Wolf:

Well, we also disagree on WWII. Thats not correct in either country.

Again, its never worked anywhere. Ever.

And, with all due respect, because I do respect (most of) your commentary, I appreciate the fact that you think you know the Austrian approach, but from your comments, I don’t think so. But then, neither does Krugman. I have read Keynes General Theory , but I know Krugman hasn’t read any of the Austrians and hasn’t got a clue about it. If you imply that raising taxes and cutting spending is Austrian then you perhaps have been told about it or have read critiques of it by non-Austrians, but, like Krugman, have not read Mises, Hayek, Menger. Basically IS-LM is junk science, never proven, impossible to test.

Actually the Austrians have been right on most of the issues you write about and the Keynesians wrong (Krugman called the bubble, but his solutions have been wrong). Again this is not the place to debate, but you have tremendous influence in your position as a well respected writer on economics, so when I say I don’t think you’ve got the Austrian take right, its an attempt to at least not have you misrepresent it to the world. And, concerning WWII, not misrepresent history.

I’ve probably worn out my welcome, but you might wish to read Hayek’s take on why Keynesian econometrics isn’t science. It is his Nobel prize lecture. [I attached Hayeks' speech.]

Thanks for the conversation,

Jeff Harding

6

Dear Mr. Harding:

Well, my “take” is that Austrians believe a recession is the correction phase for a misallocation of resources following a long period in which the rate of interest was kept by the central bank below its “natural” rate. The need is to allow this adjustment to pass through as quickly as possible, unhindered, whereupon the economy will swiftly return to a more appropriate configuration.

[He gets it mostly right! But I think that's as far as he goes in his understanding. I clearly underestimated him.]

Martin

7

Dear Mr. Wolf:

You’ve got it right. Beats digging a hole and filling it.

And the Austrian explanation is exactly what we’ve seen in the real estate markets on this cycle. There is no under-consumption when the home equity credit card has exceeded its limit. There is no liquidity trap, because our animal spirits feel we have too much debt and a rational response to that is to save and get solvent. No amount of government flogging can change that. You well know that government doesn’t create jobs through tranfer payments and as soon as they stop digging and filling, the spending effect will just fade away as Japan discovered. This cycle is so huge that there is nothing that Ben, Tim, and Larry can do about it other than watch real estate bottom out. I don’t see thing being over until the real estate market bottoms, which is when supply drops from 10+ months back down to a normal 5-6 months. Then people will feel like spending their savings–especially when inflation kicks in and we see the whole cycle repeat itself. I see
Japan-style stagnation with the addition of inflation. Good, old fashioned stagflation.

If we started over back in November and didn’t bailout Lehman and didn’t prop up the markets we’d be out of this thing in 18-24 months, new players would easily have replaced the bad boys, and we’d be on the road to recovery.

Yet the stubborn adherence to fiscal stimulus which failed with Hoover, FDR, and Japan will only lead to bad and long term consequences. My favorite president, Cal Coolidge in 1920-1921 had a worse crash than ’29, had higher initial unemployment than Hoover (12%), and it was over in 18 months. His solution?  Do nothing. Doing much of what Keynes preached got us a 10 year Great Depression. The Dow never recovered past 1029 levels until 1955!  So you see I can’t see the point of Keynesian stimulus.

Austrians understand that interest rates are a signal to producers that consumers either want to save and not consume (they save driving down rates) or vv. If you artificially drive rates down then the signal is false and only supported by a central bank credit expansion, not consumer preferrence. Which is what killed the home builders whose production cycle is so long. Once the money dried up there was no real demand–the bubble burst.

I’ve got to tuck in now here in lovely Santa Barbara.

Thanks for the conversation.

Jeff

8

[Here we go into the issue of how to fix the banks.]

Dear Mr. Wolf:

I wrote an article on my blog entitled, “How to (Really) Fix Banks” in response to your commentary on this topic. I argue from a free market perspective. My blog is The Daily Capitalist. [I attached the article.]

Jeff Harding

9

Dear Mr Harding:

It’s a perfectly possible solution. It’s the sort of solution American conservatives have been proposing to many problems over the past three decades. It suffers from only one small problem: the chances of its being adopted are zero. Personally, I have no interest in being Don Quixote.

By the way, financial crises are not merely possible, but quite likely, even without deposit insurance.

Martin Wolf

10

Dear Mr. Harding:

The problem with the commitment not to bail out depositors is that it is completely non-credible. That means depositors will behave as if insured. This also means that when a crisis erupts, no elected government will be able to let the vast deposits in the system vanish.

The big weakness of the libertarian position is the refusal to recognise that it is absolutely incompatible with democracy.

You may be unaware that the UK had an extremely limited form of deposit insurance, as you recommend. Did people act as if they were not going to be rescued? Of course not.

So what happened when there was a run on Northern Rock? The government guaranteed deposits ex post. What would have happened if it had not done so? There would have been a run on all banks. The central bank could have acted as lender of last resort, but the banks would have soon started to run out of good collateral, since they were, in aggregate, insolvent. At this stage the government could have followed your advice and allowed the banks to collapse.. The economy would have followed.

What would have been the political consequences? Labour would have been wiped out, permanently.

The pure capitalist position is an irrelevance. It has nothing to do with practical realities.

Yours,

Martin Wolf

12

Dear Mr. Wolf:

It always hurts to be called a (i) “conservative” and (ii) irrelevant. But before we advocates of the free market are relegated to the dustbin of history, let me make a few observations.

1. My comments were directed to the US system not the UK.

2. You misunderstood the argument if you think deposit insurance would not exist if the FDIC were dismantled. It would. The big difference is that the social and economic cost of it would be borne by banks and their depositors, not taxpayers.

3. In your article you state that it would take some time to implement new, stricter capital and loan to deposit ratios. I agree, with or without deposit insurance, this must be done. So give me the benefit of at least not being a complete idiot. While we are doing this, we would also take deposit insurance private over time so as the banking system would not collapse. My guess is that insurers would line up to offer this service.

4. A private system of deposit insurance would not be subject to so much political control as government insurance [FDIC]. This is the great failure of most regulatory schemes. They rarely achieve the desired ends, and, as I point out, the ends are destructive to the economy. Government deposit insurance on top of fractional reserve banking lead directly to the meltdown. It has been shown that when the FDIC raised insurance to $250,000, banks who were in trouble actually took more risks by offering high rates on deposits to get more capital to gamble with and to help stave off the inevitable. They failed anyway. Who’s tilting at windmills, here?

5. I understand your “democracy” argument but it’s also a straw man. Your fear is that if we don’t placate the masses, we’ll find ourselves in a totalitarian system as demagogues gain power. So, if we give a little more power to the central government we’ll thwart a coup d’état. What rubbish. Maybe in the UK that’s your tradition. Here we fancy ourselves as a constitutional republic first and a democracy second. You should think about adopting a constitution. Private deposit insurance is completely compatible with our system. I am not unmindful of our history during the Great Depression and the same argument was proposed then. (If you think those New Deal regulations saved democracy, I would be delighted to argue that point as well.)

6. Your argument about lack of credibility is relevant. But not the point. You can’t just assume there would be no deposit insurance without the government. Let me ask you: where would you put your money if government policy was made clear that it wouldn’t be the banker of last resort? Would you put in a bank with private deposit insurance or one without it? It wouldn’t be a stretch of the imagination to believe that insurers would act as bank auditors to protect themselves and their shareholders. The only reason this isn’t on the table is because politicians want more power, not because it wouldn’t work.

7. I agree that there would have been a run on all banks when Northern Rock went down. So what? That is the system that now exists. That wasn’t the argument. The argument is: what is the best fix? By the way, sitting here on the shores of the Pacific Ocean I would say the idea of Labour ceasing to exist is not an abhorrent thought.

8. “Irrelevance” is not an argument. What works and what doesn’t work is an argument. I say FDIC deposit insurance made things worse. I think that’s a practical and relevant point. If you wish to cling to outmoded and failed Keynesian or Fabian socialist ideals of government action that’s your business. But at least admit the failures.

Thanks for the comments.

Jeff Harding

13

Dear Mr. Harding

Your comments deserve a serious reply. I will try to get round to it.

Martin Wolf

14

Dear Mr. Wolf:

Here is another of my impractical, loopy, free market articles that you may enjoy. I can’t help but tear Paul Krugman down. He never even attempts to be original or penetrating in his columns. You and I disagree, but you can think.

Also, I noticed an interesting statistic in another article: worldwide electricity consumption is down for the first time since WWII.

Also, I become bold and make economic predictions in: Good News vs. Bad News: Which Do You Want To Believe? It discusses things like epistemology in the context of economic prediction.

Jeff Harding