Doc, it hurts when I do this!
There’s an old joke that goes like this:
A guy goes to the doctor and says, “Doctor, doctor, it hurts when I bend my arm like this. What should I do?”
The doctor answers, “Stop bending your arm like that.”
On this blog site, I have repeatedly argued against cyclical models as predictive. Now comes a new and fascinating book entitled “This Time is Different: Eight Centuries of Financial Folly“, by economists Carmen M. Reinhart and Kenneth Rogoff. The authors use newly acquired historical data to argue that the recent economic crisis is wholly unexceptional. It is merely one more financial market driven boom-bust incident in a chain of incidents going back more than 500 years.
Their “panorama” looks at repeated patterns in which the financial machinations of business people, investors, and governments, seeking advantage, lead to riskier and riskier leveraging of debt and exchange rates until, with fateful inevitability, the house of cards collapses into a chaos of debt defaults, currency instabilities, and other perturbations of what had come to be regarded as predictable markets. In their original paper, which you can read online HERE, they offer the following chart as evidence of the cyclical nature of these events.
Nations in Default on Debt - 1800 -2006
Let’s stop for a moment and think about what we are seeing in this chart. We see periods with some semblance of order (the valleys) during which risk taking becomes increasingly reckless and stupid over time. In other words, these are the periods during which the game is afoot. The players are moving capital willy-nilly. Leveraged risk-taking based on easy credit, is increasing at an increasing rate. On paper, GDP, if you want to call it that, is skyrocketing. But greed, tunnel vision, and “this time is different” thinking, blind the players to the risks they are taking. As certain as the sunrise, each game period is followed by a sudden collapse (a peak) in which the risks come home to roost and the rules of the game are abandoned in panic (nations default on their debts and taxpayers bail-out “too big to fail” companies). All illusions of order and predictability are eroded away in uncertainty and chaos.
Thus, the “Cycle of Stupidity” can be summarized as:
- People devise a regulated and predictable economic system designed to enable the creation of, and fair and equitable exchange of, goods and services.
- People, in order to gain inequitable advantage, game the system by subverting the rules and regulations of the system and exploiting its weaknesses.
- The subversion of the system comes to be regarded as the system itself.
- The system becomes so undermined that it collapses into chaos.
- All Hell breaks loose (Blood in the streets, so to speak.)
- Return to step 1.
In an interview on the PBS New Hour, Kenneth Rogoff says,
“There’s no doubt about it. I mean, the recurring theme is arrogance and ignorance: ignorance that this has happened before in other places, in other countries; and arrogance thinking we’re special, this time is different. We have financial globalization. We’re running our economy better. “They’re lending us a lot of money because they love us and we’re doing a good job.”
From a cyclical standpoint, the only thing that is repeated is stupidity, followed thereafter by chaos and panic. In every instance, the losses realized, are unique to their time and place. In human terms, some storied few may weather the storm, but on the whole come unemployment, wars, famines, impoverishment, sadness, and misery, all in ever greater allotments.
Rogoff and Reinhart are doctors who are telling us, not that the observed patterns are themselves, predictive. What is predictive is our own stupidity. Like the old joke at the beginning of this entry, if doing something hurts you, the solution is to stop doing it.1
=====footnote——–
- See “Cycle of Stupidity”, steps 2 and 3, above. ↩
Yes and no. It would be better (?) to be able to have full use of the arm. To use the metaphor in the sense you are using it, that would entail some fix to the underlying problem.
After the system goes bust, a mad scramble takes place that is essentially ameliorative in nature. The so-called “social safety net” (to the extent there is one) is deployed (e.g. extended unemployment benefits, public works projects) and steps are taken to right the ship and, when righted, the cruise continues.
But isn’t that like trying to improve quality by reacting to the outcome? Some changes need to be made in the sytem that produces the boom/bust cycles if we want to curtail them or make them go away.
The precipitating events of this most recent bust, provide some clue as to what those changes need to be. The severity of this recession is due (most would agree) to lax regulation of financial transactions. That is where attention needs to be directed. But focus cannot be confined just to rules and enforcement. Structure of the financial sector needs to be considered. The interactions of trading and regulating agencies must be guided.
Boom/Bust cycles are said to be inherent in Capitalism, but is that really the case? Is there not some brand of capitalism that can be devised that allows it to do the things it does well (create wealth, innovate) without unacceptable social cost? Isn’t that the kind of work that needs to be done instead of devising a method to secure the doors more strongly after the barn has emptied?
Boom/Bust cycles have been recurrent, but that doesn’t mean they have to continue to be. The past behavior is not always an indicator of future trends.
Good points John, The argument in this entry is supposed to go like this:
A reasonable system is first created and as such, can be improved. In fact, the authors make reference to the introduction of standardized coinage and currency as a starting place for the system. At another point, they say, they give the example of the system being cheated by manipulation of the value of those currencies (inflation and deflation).
The system does what it does so long as the rules of the system are held constant, more or less. The arm system also, does what is does, moving this way and that way, but not ANY way. If you cheat the system by bending the arm in a way that is outside the parameters of the system, it hurts. It breaks the system. If you value the SYSTEM and it works, don’t break it. Understand its limitations, understand and reduce variation, improve it. If you keep breaking it, you will just keep getting hurt. Stop doing that
This is explained in terms of the economy, in the Fox-Penner’s Baseline Scenario blog post at:
http://baselinescenario.com/2009/11/03/peter-fox-penner-replies/
PS – See revised picture of arm.
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