How to predict the outcome of this great monetary experiment, and how we got into this box

Larry Kummer, Editor

13 years ago

Summary: Today we discuss the nature of the great monetary experiment now under weigh, with five years of zero interest rates and repeated doses of quantitative easing. What does it mean to say this is an “experiment”? If we cannot reliably predict the outcome, at least let’s understand how we got into this predicament.

What if Madame Curie built a nuclear reactor?
Why? It’s a paradigm crisis in economics
Why? Failure to reform
Why? Failure to learn
Conclusion
For More Information

(1) What if Madame Curie built a nuclear reactor?

The vital thing to know about the great monetary experiments began in 2008 – now underway in Japan, Europe, and America — is that these are experiments. There are no clear precedents, and certainly no successful precedents. Even the conditions are unique: stratospheric debt levels (both public and private) — aging populations — and a global financial system like nothing before.

That means those precise descriptions of possible outcomes we read, often giving odds of several outcomes, are just fancy guesses. Our gurus’ so confident predictions should be regarded as helpful guides to possibilities, nothing more. Things might evolve in ways we cannot now imagine. We cannot see into the next chapter, when the Fed tapers its purchases (or expands them if the economy slows).

Let’s try a Gedankenexperiment (thought experiment). Imagine if in 1910 Madame Currie not only refined a ton of pitchblende into 1/10 oz of radium, but then went on to produce much more. She shapes them into pellets, puts them into a bowl, and … something unexpected happens. A flash of blue light! Two days later she dies. It was a subcritical nuclear reaction (aka a criticality accident, see Wikipedia). Something she had no way to predict or understand. Experiments are like that.

If we can only guess at what happens next, we can know how we got into this fix.

(2) Why? It’s a double paradigm crisis in economics

Economists as a group have produced mostly incorrect predictions during the past decade, especially failing to predict the major events. The great crash, the sluggish recovery, and the Europe crisis starting in 2010. Here are two possible reasons.

(a) We are living a Thomas Kuhn-type paradigm crisis in Keynesian economics, the theories by which the world economies have been steered for fifty years. In them the aggregate debt level of an economy is not a significant variable; attempts to integrate debt levels into orthodox theory by radical Keynesians (e.g., Hyman Minsky) were largely unsuccessful.

Debt levels, public and private, skyrocketed after 1980. Sometime after 2000 we reached and broke though the edge of the “operating envelope” of Keynesian theory. We ran like Wile E. Coyote off the cliff and beyond — a few exhilarating years — fell, and now we struggle to climb back.

(b) Economists’ models are mechanical, not organic.

Mainstream economics assumes a mechanical model of the economy. Turn the monetary crank clockwise and the red rod rises; turn it counter-clockwise and the red rod lowers. While analytically simple, it is quite daft to imagine the American economy works like that.

Large complex systems work differently. They adapt to inputs in subtle ways. Withdrawal of the input does not restore the status quo ante, instead it produces unpredictable new effects. Consider Prozac. Withdrawal from Prozac brings on strange new problems, not just the original depression.

(3) Why? Failure to reform

A defining characteristic of this cycle has been the major nations unwillingness to learn. After the crash the USA had an extra-large New Deal without any of the New Deal reforms. Europe has staggered along since its crises in 2008 and 2010 without any of the desperately needed reforms. The third arrow of Abenomics remains MIA. And the big expectations for reform from China’s Third Plenum meeting were predictably disappointed.

The massive response to the crash successfully stabilized the world economy, but that success drained the energy that should have driven reforms — reforms that could have laid the foundation for another generation of growth.

(4) Why? Failure to learn

On 1 July 1916 General Haig sent the British Fourth Army and French Sixth Army over the wire. That day they took over 57 thousand casualties. In some better alternate world, having achieved nothing and lost all tactical surprise, he called off the attack and ordered a complete rethink of their tactics. But in this world he continued the attack for another 140 days, advancing 6 miles at a cost of 624 thousand casualties.

We might surpass that record of stupidity (but fortunately not in terms of blood shed). Japan remains locked in stagnation since 1989 as its government debt goes to levels where no nation has gone before; it’s latest nostrum — Abenomics — so far has failed to achieve most of its objectives. The US remains at stall speed since 2010, despite running large fiscal deficits and two rounds of quantitative easing. Europe doggedly pursues a course with high odds of wrecking the societies of its southern members.

Perhaps we have grown sclerotic, a side-effect of our rapid aging. If it wasn’t for our dysfunctional political system, our younger demographics and higher fertility could be a competitive advantage.

(5) Conclusion

{Frito} remembered Bromosel’s ill-omened dream and noticed for the first time that there was a large blotch of lamb’s blood on the warrior’s forehead, a large chalk “X” on his back, and a black spot the size of a doubloon on his cheek. A huge and rather menacing vulture was sitting on his left shoulder, picking its teeth and singing an inane song about a grackle.

— From Bored of the Rings by Douglas Kenney and Henry Beard (1969)

All of this is quite obvious. Why then do we — optimists and pessimists alike — so strongly hold to our illusion that the outcome of this cycle is predictable? My guess (emphasis on guess): fear. We have used our illusions to suppress this fear, instead of allowing it to drive us to greater unity or creativity.

Perhaps fear will return, and arouse us to address our problems. Whatever the resolution, we will learn much from the next few years. Interesting times lie ahead.