The Social Impact of Economic Assumptions (in one chart)

Zach Goldfarb at the Washington Post has a perplexing piece about how a Summers Fed would look like. It was so perplexing that Brad DeLong at U.C. Berkeley simply copied and pasted it into his blog and let the comments fly (many of them are interesting). When I read the article, the cognitive dissonance made my daily Tylenol intake go up.

One of the peculiarities of particularly bad Microeconomics is that it often assumes human behavior in a way to make it fit their models, instead of making their models fit social facts. To do so would require them to actually “study” human behavior. Such is the case in the Larry Summers debate.

Goldfarb makes the case that Summers would help unemployment, unfreeze credit markets, while dancing on the edge of the sword between inflation and forcing banks to have a big cash reserve in case of failure. That’s pretty much what the Fed has been trying to do since 2008, and it hasn’t worked out very well. So in essence, Goldfarb is arguing that a Summers Fed would look exactly the same as a Bernanke Fed. Except no one can see Summers in this light (more on that in a minute).

Basically, in an attempt to unfreeze credit market at the consumer level, the Fed has been pumping money into the Economy for the last 5 years under QE (Quantitative Easing). When the Fed pumps money into the Economy, it does so through banks. Here’s what’s happened over the last 5 years to all the money that gets pumped into banks by the Fed (according to Fed Data itself):

Liquidity

The negative correlation is that the money that banks get from the Fed (money stock) just sits there and rots (r= -.85). The more the Fed gives, the more that rots. Banks have used this money for exactly what Goldfarb claims Summers wants to do: have big reserves. Having big reserves may not be a bad thing, because it reduces a bank’s likelihood of failure. QE has done well in keeping banks alive, when they were once like a gangrenous puss-filled blister on the economy.

However, this chart not only shows the Liquidity Trap (in living color), but also the frozen credit market, the failure of Capital infusions, the reason for the Zero Lower Bound, and ultimately, why Unemployment is so damned high that people are degraded – all in one chart. Having big reserves (courtesy the Fed) in a Liquidity Trap also means less money in the economy for everyone else, which impacts aggregate demand, employment, and GDP (a.k.a Wealth), along with all of the former.

And let’s not forget my “Credit is not the same as Wealth” battle cry.

There’s a few problems with the idea that Summers would be as hawkish as Bernanke: Larry Summers has never behaved in any manner to indicate that he would ever behave that way in the future. The old mantra “past performance is no guarantee of future results” has a new twist; there was never any “past performance” to begin with. Goldfarb, like most bad Social Scientists (which I have no idea if he is one or not), is assuming human behavior based on, well, nothing.

Larry Summers was one of the key players in creating unregulated derivatives that were the fuse to the dynamite that blew up the economy, while he was drunk on power and money. While the drunk driver may feel really bad for killing that family of four on the highway, do we really want that drunk driver to get behind the wheel again? It’s dangerous for society to assume that somehow, this time, he will be different.

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