naked capitalism: Iceland Proves That in a Financial Crisis, Breaking Glass and Trashing Currency is a Good Remedy

naked capitalism: Iceland Proves That in a Financial Crisis, Breaking Glass and Trashing Currency is a Good Remedy: "Iceland ground zero for the most spectacular banking industry boom and bust in the history of man. Iceland managed to go on a debt party that saw its obligations soar to 850% of GDP, leaving America at a mere 350% firmly in the dust.

So how is Iceland faring now? One would assume still broke and chastened. One would be dead wrong.

The krona is down 50% from its peak, and it seems to have sparked a speedy revival. ...But Iceland and the Nordic countries can make move like that without precipitating competitive devaluations. What works individually does not work collectively."

Economist's View

Economist's View: "I was asked what went wrong that caused economists to miss the financial crisis. For me, a key part of it was the belief in the risk distribution model. Let me give a simple example of how risk distribution works:"

In short: distributing risk does not reduce overall risks, it just distributes the costs more evenly. This causes enough moral hazard which increases risks and if the total risk increases enough, then the entire system can collapse.
See the end of the post for more links about how the financial crisis happened and also see this letter to the Queen.

Grasping Reality with Both Hands

Grasping Reality with Both Hands: "Everybody loves this chart. Nobody can explain it without long and detailed notes. I certainly cannot..."

Marginal Revolution: Independent Central Banks and Inflation

Marginal Revolution: Independent Central Banks and Inflation: "The primary reason that independent central banks are better at controlling inflation is that absent direct political control the default selection mechanism favors bankers, i.e. lenders, people whose interests make them more favorable towards lower inflation.

Thus, independence is a political decision that favors lenders in the decisions of monetary policy."

Financial economics: Efficiency and beyond | The Economist

Financial economics: Efficiency and beyond | The Economist:

"Mr Thaler concedes that in some ways the events of the past couple of years have strengthened the [efficient market hypothesis]. The hypothesis has two parts, he says: the “no-free-lunch part and the price-is-right part, and if anything the first part has been strengthened as we have learned that some investment strategies are riskier than they look and it really is difficult to beat the market.” The idea that the market price is the right price, however, has been badly dented."

This is part of a has a great series on recent events in Macroeconomics in the Economist magazine :

• The state of macroeconomics
  Jul 16th 2009
• Where economics went wrong
  Jul 16th 2009

The Quiet Coup - The Atlantic (May 2009)

The Quiet Coup - The Atlantic (May 2009): "The crash has laid bare many unpleasant truths about the United States. One of the most alarming, says a former chief economist of the International Monetary Fund, is that the finance industry has effectively captured our government—a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises. If the IMF’s staff could speak freely about the U.S., it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform. And if we are to prevent a true depression, we’re running out of time."

The Science of Economic Bubbles and Busts: Scientific American

The Science of Economic Bubbles and Busts: Scientific American: "The worst economic crisis since the Great Depression has prompted a reassessment of how financial markets work and how people make decisions about money"

Worthwhile Canadian Initiative: The State(s) Theory of Money: California and Canadian Tire

California is issuing IOUs ("scrip") instead of money because it spends more money than it has.  It is legal for anyone to make their own local money as long as it does not look like a Federal Reserve note (counterfeit) and it is not a scheme for avoiding taxes on income. 

Worthwhile Canadian Initiative: The State(s) Theory of Money: California and Canadian Tire: "there is a distinct chance that California will allow taxes to be paid in the new scrip it issued when it ran out of funds. I have no idea whether this will happen, or whether the Federal government will stop it. Let me just assume that it does happen, and that the Federal government does not stop it. I'm (almost) hoping that it does happen, and that the Fed doesn't stop it, because it would be such a fascinating experiment in monetary theory.

Assuming this experiment does go ahead, what are the chances that California scrip will circulate as a medium of exchange?"

Matthew Yglesias » Home Page

Matthew Yglesias » Home Page:
"One of the most worrying things about the current economic situation is that in recent recessions the lag has been loooooong. Take this chart from Brad DeLong about the last recession: Brad says, “A recovery in which unemployment is higher two years later than when the recovery began is not much of a recovery. And I don’t see what is going to keep the probability of such an eventuality low.”

I think the theoretical issue here is that as time passes, and growth happens, and technology progresses the labor market gets more advanced and more specialized. In general, this is a sign of good things happening. But the more advanced and specialized the economy becomes, the more difficult it is to make structural adjustments quickly. And when pulling out of a big recession, that’s a big problem."

The paradox of thrift — for real - Paul Krugman Blog - NYTimes.com

The paradox of thrift — for real - Paul Krugman Blog - NYTimes.com: "The paradox of thrift — for real

The paradox of thrift is one of those Keynesian insights that largely dropped out of economic discourse as economists grew increasingly (and wrongly) confident that central bankers could always stabilize the economy. Now it’s back as a concept. But is it actually visible in the data? The answer is, and how!

The story behind the paradox of thrift goes like this. Suppose a large group of people decides to save more. You might think that this would necessarily mean a rise in national savings. But if falling consumption causes the economy to fall into a recession, incomes will fall, and so will savings, other things equal. This induced fall in savings can largely or completely offset the initial rise.
Which way it goes depends on what happens to investment, since savings are always equal to investment. If the central bank can cut interest rates, investment and hence savings may rise. But if the central bank can’t cut rates — say, because they’re already zero — investment is likely to fall, not rise, because of lower capacity utilization. And this means that GDP and hence incomes have to fall so much that when people try to save more, the nation actually ends up saving less.
The theoretical picture looks like this:

The line labeled I shows how investment spending depends on GDP. S1 is the original savings-GDP relationship; it shifts up to S2. The effect of this upward shift in desired savings at any given level of GDP is, paradoxically, a fall in actual savings and investment.
What does this look like in actual data? Strictly speaking, the figure above shows an economy without trade. If you add in imports and exports, the paradox of thrift becomes less likely, because you country’s reduced consumption comes partly at the expense of imports rather than domestic GDP. So I wasn’t sure what it would look like for the United States.
But here are the changes in total net saving and its components between 2007IV, the last pre-recession quarter, and 2009I, from the BEA:

Sure enough, the sharp increase in personal saving has been accompanied by a decline in overall national saving — partly via reduced corporate savings, largely via increased public deficits.
One caveat: some of the decline in investment, and hence in saving,is due to disruption in the credit markets. Still, my sense is that the big reason for declining business investment, at least, is simply the fact that consumer demand has fallen — which is paradox of thrift in action.
One key implication of the fact that we’re living in a paradox of thrift world is the folly of demands that we reduce budget deficits in the near term. Slashing spending or raising taxes right now wouldn’t just deepen the slump — it would actually make us poorer in the future, too, because it would lead to lower overall saving and investment.
Now, we won’t always face the paradox of thrift. But right now it’s very, very real."

Gold standard

Wikipedia, the free encyclopedia:

The history of money consists of three phases: commodity money, in which actual valuable objects are bartered; then representative money, in which paper notes (often called 'certificates') are used to represent real commodities stored elsewhere; and finally fiat money, in which paper notes are backed only by use of' 'lawful force and legal tender laws' of the government, in particular by its acceptability for payments of debts to the government (usually taxes).

Commodity money is inconvenient to store and transport. It also does not allow the government to control or regulate the flow of commerce within their dominion with the same ease that a standardized currency does. As such, commodity money gave way to representative money, and gold and other specie were retained as its backing.

...A 100% reserve gold standard, or a full gold standard exists when the monetary authority holds sufficient gold to convert all circulating money into gold at the promised exchange rate. It is sometimes referred to as the Gold Specie Standard to more easily identify it from other forms of the gold standard that have existed at various times. A 100% reserve standard is [nearly impossible] to implement as the quantity of gold in the world is too small to sustain current worldwide economic activity at current gold prices. Its implementation would entail a many-fold increase in the price of gold. Furthermore, the "necessary" quantity of money (i.e. one that avoids either inflation or deflation) is not a fixed quantity, but varies continuously with the level of commercial activity.

I usually find that Wikipedia does a great job, but this entry goes off track in several places. For example, Wickipedia says that an advantage of the gold standard is that it would require periodic deflation. That was actually a major problem. Deflation is very destructive because it nearly eliminates banking.
Wikipedia also says, "Many liberal economists believe that economic recessions can be largely mitigated by increasing money supply during economic downturns.^[17]" but this is part of mainstream conservative economics too. As evidence, Wikipedia cites Greg Mankiw who is a conservative economist. Conservative economists have actually pushed the importance of active monetary policy much more than liberal economists because many conservative 'monetarists' like Milton Friedman wished to reduce the reliance on Keynesian government spending during recessions. That was a big reason for the conservative school of thought known as monetarism.  Another problem is that Wikipedia cites Alan Greenspan as a prominent proponent of the gold standard, but he abandoned that idea at least three decades ago when he went to work for the Fed and was put in charge of fine-tuning the money supply. Wikipedia also says:

Representative money and the gold standard protect citizens from hyperinflation and other abuses of monetary policy, as were seen in some countries during the Great Depression.

Representative money does not always protect citizens against hyperinflation because governments can always devalue the representative money. The Great Depression is a ridiculous example because it is better characterized as a period of deflation rather than inflation and governments generally devalue currencies during crises like that. As Milton Friedman documented, the main abuse of monetary policy in the depression was that governments did not expand the money supply (and devalue the currency) enough (nor quickly enough).  A big part of the problem was a desire to remain on the gold standard. Wikipedia goes on to contradict itself:

... the earliness with which a country left the gold standard reliably predicted its economic recovery from the great depression. For example, Great Britain and Scandinavia, which left the gold standard in 1931, recovered much earlier than France and Belgium, which remained on gold much longer.

A huge amount of the total gold in the world is still held by central banks as a kind of reserve currency for foreign exchange manipulation and to diversify risk.

...The total amount of gold that has ever been mined has been estimated at around 142,000 metric tons.^[12] Assuming a gold price of US$1,000 per ounce, or $32,500 per kilogram, the total value of all the gold ever mined would be around $4.5 trillion. This is less than the value of circulating money in the U.S. alone, where more than $8.3 trillion is in circulation or in deposit (M2).^[13] Therefore, a return to the gold standard, if also combined with a mandated end to fractional reserve banking, would result in a significant increase in the current value of gold, which may limit its use in current applications.

Grasping Reality with Both Hands

Grasping Reality with Both Hands: "The American economy appears to be nearing the end of contraction. That's good news, particularly when one considers that only about 10% of the funds authorised in this year's stimulus bill has been spent; the plan is only beginning to ramp up and outlays will peak in 2010. We should expect that injection to provide the economy with a nice boost at a critical time.

On the other hand, state budget policies are sharply contractionary at this point. Despite allocations of federal aid to states, services are being cut, state employees are being laid off, and taxes are being raised in order to balance the budgets of local governments constitutionally unable to run deficits. It's not at all clear that the federal stimulus will entirely compensate for state-level fiscal tightening, which means that American fiscal policy could, on net, be contractionary."