Saturday, December 20, 2008

What Seems to Have Happened to the Economy

We were using nonexistent money to buy things. Not exactly -- the money did exist on paper, and often that's as far as money ever gets -- but it was nonexistent in the sense that the valuations (for e.g., house prices, mortgage-backed securities) were not supported by actual money that someone had. There was not enough money in the world to support the valuations. For instance, when subprime mortgages began to go underwater, there were not enough buyers at the supposed price levels to maintain those prices. In this interpretation, we are now in the process of adjusting the actual amount of money in the world to match the paper valuations of everything. We are doing this in two ways: by reducing the paper valuations via deflationary market pressures (where prices drop because people are no longer willing to supply the same amount of money as before in order to buy something), and by increasing the amount of money available. At some point, we will reach equilibrium, where prices will have dropped far enough and/or enough money will have been created. We will presumably reach equilibrium at relatively higher prices if we create lots of money very quickly; or equilibrium will come later, at lower prices, if the rate of price drops exceeds the rate of money creation. Money can be created in different places, for the benefit of different people. A bailout plan for banks replaces their nonexistent money with existent money, insuring that the banks stay afloat. A bailout plan for other kinds of debtors (e.g., auto companies, school systems, individuals) would do the same thing for them. The decision of where to create the money is apt to be steered by politics, where the people who have money tend to complain louder and make more trouble if they lose money, at least to a certain point. Not creating any money would reward those people who valued assets conservatively -- who, for example, did not assume that the temporarily inflated values placed upon their homes were available to be tapped for spending. But it would reward them in a negative sense: they would be the only people who were not wiped out by financial calamity. If they happened to be surrounded by neighbors who went wrong, it might develop that many houses would become vacant, in which case the fiscally conservative individuals might experience a loss in the value of their own assets. Or, in the case of banks, if money vanishes to such an extent that there is not enough money to cover all deposits, then banking as a whole might suffer, as people began to consider it safer to stash their cash in their mattresses. The flaw of the conservative approach is that it fails to provide a safety net. If you are determined not to let banks, communities, or individuals completely fail and go belly-up, then people know that the worst case will not be absolutely horrible, and it becomes possible to imagine letting the bad planners take a bath. Let the smart ones win, flush out the dummies, but make sure everyone lives to fight another day. In other words, if your competition becomes too cutthroat economically, then eventually it will become unpalatable politically. You've got to balance penalty and safety for the losers. By that priniciple, the place to create money is wherever people are lacking a safety net.