The Free Thinker

New Book

Just published my first book-- co-authored with Dr. Charles Rowley.  Well, I guess it's not my first: I also co-authored this one back in 2004.  The title: Economic Contractions in the United States: A Failure of Government.  Here's the summary from the back of the book:

Seeking "not to let a crisis go to waste," left-leaning politicians and old-style Keynesian economists want to remedy the alleged failure of capitalism with a rising tide of big government. Let the budget deficits rip, empower the unions, socialize healthcare, increase trade protection, go green, and socialize the financial and industrial base. The irony, as Charles Rowley and Nathanael Smith show in this timely monograph, is that the Keynesian policy prescriptions that are serving as the pretext for this program have already been tried. Expansionary fiscal and monetary policies by the Bush administration and the Greenspan Fed were implemented to deal with the recession of 2001, and are precisely what caused the current crisis.

Applying sound economic reasoning and cutting-edge public choice theory, Rowley and Smith show that both the Great Depression and the current economic contraction were caused by failures not of capitalism, but of government. While monetary policy was the primary culprit in the 1930s, the interventionist policies of the Hoover and Roosevelt administrations exacerbated the downturn and stifled recovery. Fortunately, the monetary policy of the independent Fed is much better now (though the Fed has unduly widened its role), but elected politicians are pursuing policies of intervention and re-regulation similar to those pursued in the 1930s. If these adverse trends are not reversed, the dynamic laissez-faire capitalism of the United States will be assimilated to the state capitalism and economic stagnation of Western Europe.

By ending an era of big government, America in the late 1990s achieved the longest economic boom in its history, with unemployment falling lower than economists had thought possible, and an acceleration in the growth of productivity. Prosperity and full employment can only be restored by the same means. The authors outline a radical free-market approach to policy reform designed to restore the United States economy to its stellar performance during the final fifteen years of the 20th century.

We actually put a lot of the blame for the crisis on Bush and his Keynesian policies.  And even more on the Greenspan Fed, although the sharpest rhetoric is directed at Democratic politicians.  We go back to the Great Depression and castigate FDR, too.  Nobody comes out looking particularly good.  Well, I guess Reagan and Clinton do. 

Also available on Amazon for $12.

Not Stimulus; Austerity

"Asia: An astonishing rebound" (Economist, 8/13)

IT NEVER pays to underestimate the bounciness of Asia’s emerging economies. After the region’s financial crisis of 1997-98, and again after the dotcom bust in 2001, outsiders predicted a lengthy period on the floor—only for the tigers to spring back rapidly. Earlier this year it was argued that such export-dependent economies could not revive until customers in the rich world did. The West still looks weak, with many economies contracting in the second quarter, and even if America begins to grow in the second half of this year, consumer spending looks sickly. Yet Asian economies, increasingly decoupled from Western shopping habits, are growing fast.

The four emerging Asian economies which have reported GDP figures for the second quarter (China, Indonesia, South Korea and Singapore) grew by an average annualised rate of more than 10% (see article). Even richer and more sluggish Japan, which cannot match that figure, seems to be recovering faster than its Western peers. But emerging Asia should grow by more than 5% this year—at a time when the old G7 could contract by 3.5%. Western politicians should brace themselves for more talk of economic power drifting inexorably to the East. How has Asia made such an astonishing rebound?...

Asia’s rebound has several causes. First, manufacturing accounts for a big part of several local economies, and industries such as cars and electronics are highly cyclical: output drops sharply in a downturn and then spurts in the upturn. Second, the region’s decline in exports in late 2008 was exacerbated by the freezing up of global trade finance, which is now flowing again. Third, and most important, domestic spending has bounced back because the fiscal stimulus in the region was bigger and worked faster than in the West. India aside, the Asians entered this downturn with far healthier government finances than rich countries, allowing them to spend more money. Low private-sector debt made households and firms more likely to spend government handouts; Asian banks were also in better shape than their Western counterparts and able to lend more. Asia’s prudence during the past decade did not allow it to escape the global recession, but it made the region’s fiscal and monetary weapons more effective.

We haven't seen results like this from stimulus in the US, and we probably won't. Although some economists on the left are crowing that the recovery that might be beginning shows the stimulus is working-- this is silly for three reasons: (a) the economy has a natural tendency to recover, and did so long before government started engaging in Keynesian "stimulus," (b) little of the stimulus money has been spent, (c) the Fed's monetary policy is more than enough "stimulus" to explain the recovery. And it should not be forgotten that the projections prior to the stimulus had unemployment rising to only 8% or so without the stimulus.  If you believe that, the stimulus must have made things worse.  If not, that's just a reminder that economic forecasting is pretty unreliable, and credit-taking by politicians has a lot to do with opportunism and not much to do with truth.  In any case, America's recovery is so far and is likely to remain far less robust than Asia's.

Which raises the question: Why does stimulus work better in Asia than here?  Because in Asia, stimulus could push the economy in a direction it needed to go anyway.  Asia was saving more than it could invest and moving the money abroad.  It had better things to do with the money at home.  Also, I don't know the details, but I'd bet that there are a lot more high-value-added public investment projects that Asia hasn't done yet than that America hasn't.  America, by contrast, really needs to save and invest.  The people are trying to do that, but the government is stopping them by soaking up the savings with mega-deficits.  What we need is not stimulus but austerity: to stop runaway government spending and leave room for private investment to grow into the gap.

Peggy Noonan, "'Shrink to Win' Isn't Much of a Strategy" (May 1, 2009):

In the party now there is too much ferocity, and bloody-mindedness. The other day Sen. Jim DeMint said he'd rather have 30 good and reliable conservative senators than 60 unreliable Republicans. Really? Good luck stopping an agenda you call socialist with 30 hardy votes. "Shrink to win": I've never heard of that as a political slogan.

Is it fully mature, and truly protective toward America, to be so politically exclusionary?...

Republicans are also up against themselves. On Capitol Hill they are up against the Bush era, when through fear of the White House or mindless opportunism they supported things they now decry. It will take them a while to seem credible again. The smarter of them know this. They're waiting for time to pass and a new cliché about them to take hold. Old cliché: "They're not a credible alternative." Future cliché they hope for: "They've learned a lot in the wilderness."

I'm with Jim DeMint on this one.  I would like to see some change in the Republican Party, most obviously on immigration reform, but it's the electorate, not the Republicans, that needs to learn a lot in the wilderness of the Obama economy.  Right now the electorate is a bit like a man who became falsely convinced that his wife was cheating on him, walked out, and is in a bar drinking himself to death.  Obama is the beerglass; the beer, of course, is deficits.  There's no use talking sense to an electorate (and punditocracy) as crazed as the one that produced the catastrophe of 2008.  Any appeal to history or logic will be ignored or start a barfight.  A change has to come from him, from within, before he can be receptive to help.  In the meantime, we can just sit on the sidelines and watch sadly as a great civilization destroys itself.

Why Military Spending Provides the Best Stimulus

In the 1930s, FDR engaged in a lot of deficit spending. It didn't really work. One might argue that it partly worked, since there was some recovery from 1933-37. I would argue that that was because of banking reforms and expansionary monetary policy in those years, and that the deficit spending probably did less than nothing to help the recovery. In any case, the economy at its peak in 1937 was still below its 1929 levels, the only time in American history that the peak of one business cycle has fallen short of the peak of the previous one. Fiscal policy worked feebly at best.

Then came WWII, when the government borrowed and spent like crazy and the economy-- at least, according to GDP statistics-- came roaring back. Advocates of fiscal stimulus these days never cite FDR's deficit spending in the 1930s, they cite WWII in favor of their policy recommendation. And it does seem that there have been several episodes in which military spending has served as an economic stimulus. It did so in Hitler's Germany starting in 1933, when Hitler spent heavily on rearmament. It seems to have done so in the United States in the 1960s, as the Vietnam War helped us through a long-lasting boom. And an increase in deficit defense spending may have fueled the comparative (at least, to today!) prosperity of 2003-2006. I am aware of no examples of successful Keynesian fiscal stimulus that were not based on military spending. There is at least one apparent massive failure: Japan in the 1990s, where fiscal stimulus bought only a decade of stagnation and put the country up to its neck in debt.

If this empirical pattern is accurate, what is the explanation? Why does military spending work better than other kinds of spending? I can think of three reasons:

1. Military spending systematically distorts measured GDP. In ordinary times, GDP may be considered to be a decent indicator of human welfare, since it is built on market prices that reflect the "revealed preferences" of individuals. If the economy produces a lot of new stuff that is basically worthless, that raises Soviet GDP since widespread fixed prices and queues prevent people from revealing their real preferences, but it wouldn't raise US GDP because the stuff would sell for next-to-nothing if at all, and would be priced into GDP accordingly. But military spending is typically not mediated through the market, or at most through highly restricted and politicized markets like defense contracting. Money-value becomes disconnected from utility theory and revealed preference. GDP was higher during WWII in large part because we were producing lots of planes and bombs and warships etc. which we priced at certain levels, but these things weren't making anyone any happier (at least, not in the way potatoes or pizzas or pianos or palaces do). By this account, the effectiveness of military fiscal stimulus is a statistical illusion.

2. During wartime, the rights of workers tend to be restricted, enabling the government and employers to work them harder. Certainly in Hitler's Germany, the rights of labor were curtailed. I think it's also the case that union activism died down in the US in the 1940s relative to the 1930s. And the draft is a curtailment of the rights of workers which has no parallel in peacetime. I'm not saying any of this is good, but it might tend to raise GDP.

3. This is the most important. Defense spending is temporary. A general problem with Keynesian economics is that it assumes policy is made by farsighted and disinterested technocrats, whereas in reality it is made by politicians beholden to all manner of special interests and none too bright themselves and looking for short-term electoral gain and partisan reputation. Once a program is introduced, it creates a constituency for itself and is then difficult to reverse, no matter how obsolete its original rationale becomes. An increase in long-term government spending, if we make the sensible if suddenly unfashionable assumption that government spending is less efficient than private spending, will tend to reduce GDP. An increase in short-term government spending when resources are unemployed might, in theory, increase GDP by employing some of these resources. But if a given increase in government spending is expected to be long-term rather than short-term it will be more likely to crowd out private spending than to increase overall spending (long Keynesian story behind that, and it could be disputed on various grounds, but I say it for the sake of argument).

What is unique about war is that, unlike all other forms of government spending, it is inherently and credibly temporary. The Iraq war is possibly an exception to this since it seems to be the expression of a new foreign-policy doctrine which implies more war than previously expected. Still, war does not create a constituency for its continuation in the same sense that other government programs do, for the simple reason that it is unpleasant, and most unpleasant for the "beneficiaries" in a narrow fiscal sense, namely, the soldiers who get paid (not very much) to do the fighting and dying in it. Of course, defense contractors and congressional districts hosting military bases may have an interest in keeping war going. But it's reasonable for private sector investors to expect, "We'll fight for a while, we'll win the war, and then we'll come home and spending will fall."

With other government spending, though they may have some tendency to be cyclical, the best predictor of future levels of spending may be present levels of spending plus the trend in the level of spending. An investor thinks: "Uh-oh, we're spending a lot more now, probably we'll spend that much more forever. So we're all poorer. I guess I'd better spend less, in order to save more and be ready for this poorer future."

"663,000 Jobs Lost in March; Total Tops 5 Million" (NY Times)

With 663,000 more jobs disappearing from the American economy last month, swelling the total number of jobs surrendered to the recession beyond five million, the government’s response to the downturn is being put to a strenuous test.

When drafting plans in January to spend roughly $800 billion to stimulate the deteriorating economy, the Obama administration operated on the assumption that the unemployment rate would reach 8.9 percent by the end of the year — without the extra federal spending. Three months into the year, the unemployment rate has already soared to 8.5 percent, from 7.6 percent, the highest level in more than a quarter-century.

Between January and March, more than two million jobs were lost, according to the Labor Department’s employment report, released Friday.

The severity and breadth of the job losses in March — which afflicted nearly every industry outside of health care — prompted economists to conclude that an agonizing plunge in employment prospects was still unfolding.

“It’s really just about as bad as can be imagined,” said Dean Baker, a director of the Center for Economic and Policy Research in Washington. “There’s just no way we’re anywhere near a bottom. We’ll be really lucky if we stop losing jobs by the end of the year.”

The pace of retrenchment has prompted talk that another wave of government stimulus spending may be needed to accompany the $787 billion already in the pipeline.

“We’re clearly looking at a worse downturn than they had been anticipating when they planned the stimulus,” said Mr. Baker, whose organization tends toward liberal policy prescriptions. “We’re going to need some more.”

If stimulus actually suppresses employment by raising expectations of future taxes and thereby reducing business investment, as well as by taking resources out of productive private sector activities into less productive government activities, we could be in for a nasty vicious cycle of "stimulus" leading to job losses, leading to more demands for "stimulus."  Probably that won't happen though.  Probably what will happen is that the economy will recover in spite of the "stimulus"-- this is just the normal operation of the market process-- and then the Obama administration and the liberal media will credit it to the "stimulus."

"Stimulus Thinking, and Nuance" (David Leonhardt):

Here in the United States, many people are understandably wondering whether the $800 billion stimulus program will make much of a difference. They want to know: Does stimulus work? Fortunately, this is one economic question that’s been answered pretty clearly in the last century.

Yes, stimulus works.

When governments have taken aggressive steps to soften an economic decline, they have succeeded. The Germans did it in the 1930s. Franklin D. Roosevelt did so more haltingly, and had more halting results. Even the limp Japanese recovery plan of the 1990s makes the case. Although dithering over a bank rescue kept Japan in a slump, government spending on roads and bridges made things better than they otherwise would have been.

What?  How are we supposed to know how things "otherwise would have been" in Japan without stimulus?  It's possible they would have been worse, but surely the best baseline assumption would be to guess that without the Keynesian boondoggles, Japan in the 1990s would have been like a normal business cycle, down for a bit and then back to its growth trend.  What is one to make of an argument that placidly counts Japan's Lost Decade as a success and expects us to go along with it.  And it is worth noting that when the Asian crisis hit other Pacific Rim countries which, having fewer reserves, had to come under IMF tutelage and accept austerity measures, the opposite of Keynesianism, they did not run into a lost decade, but rebounded dramatically.

FDR's large deficits in the 1930s left US GDP below trend for a decade.  It's true that German rearmament seems to have fuelled recovery in Germany in the 1930s, and WWII in the United States in the 1940s.  But there are several problems with this.  First, war and defense spending distort measured GDP, because they involve producing lots of stuff that doesn't increase anyone's utility and is not priced in the market.  Measured American GDP grew a lot in WWII, but Americans, subject to rations or fighting, were not necessarily living any better.  So in Germany.  Second, war involves such wide-ranging changes to the economy-- especially a total war like WWII-- that it's hard to know which of the huge changes is having an effect.

Also, in the 1930s unemployment was so high that government spending was much less likely to displace private sector activity.  It's easy to see the theoretical reason why extra government spending might be helpful when unemployment is 25%, but harmful when unemployment is 10%.  A more general problem is that there are just too few datasets, too many factors involved, and too much vagueness in the theory itself for Keynesian stimulus to receive proper empirical testing. 

The bottom line is that there is no evidence to speak of that Keynesian stimulus works. 

Debt-Deflation

Ed Glaeser:

In the stock market, crashes can happen in hours or even minutes.  In the housing market, crashes take months and years.  Homeowners with their houses on the market, don’t just get up one morning, smell the coffee and decide to reduce their asking prices by forty percent.  It takes time for people to recognize that a bubble has burst, and plenty of sellers never do.  They just sit on their homes for years until the market turns around. 

As we are in the midst of the slowly unfolding collapse of the greatest housing price bubble in the short history of well recorded housing prices, each month’s data brings little change.  Instead, month after month, we got the slow wheeze of a bubble bursting.  The January 2009 Case-Shiller house price data, released this morning, by Standard and Poor’s, looked a lot like last month’s data. The decline between November and December for the composite 20 index was 2.6 percent; the decline between December and January was 2.8 percent.    Don’t get excited by the fact that last drop was a little higher: those numbers are essentially indistinguishable. 

The cities on sand—Phoenix and Las Vegas—continued to have some of the biggest price declines.  Phoenix prices dropped by 5.5 percent between December and January; they fell by more than five percent between November and December.  Las Vegas’ price declines have been trending at 4.5 percent down per month.  If the trend continues, by February, Phoenix prices will have dropped by more than 50 percent since the peak. 

I am somewhat surprised that these markets aren’t starting to settle down.  The defining characteristic of these two areas, and many other affordable, growing places like Dallas and Houston, is that their ability to supply housing is essentially unlimited.  Since builders can produce housing in practically enormous quantities at reasonable prices, and land is essentially infinite, it was always a little absurd for people to pay so much more than construction costs for housing in these areas.  But now prices are converging back on construction costs, which is where I had thought that they would land.  However, the rate of decline isn’t slowing, and it now looks as if prices might dip below these costs.  If that happens, then building will essentially cease.  This would be a colossal change, since the Phoenix and Las Vegas areas together permitted more than 30,000 units last year.

After these two places, the most diminished housing markets are in California and Florida. San Francisco, Miami and Tampa all continued to have dismal months. Prices in Los Angeles and San Diego each did slightly better, dropping by about 2.7 percent, but that looks good only by comparison. Prices in these five areas have declined by about 40 percent relative to the peak. These areas had some of the biggest price booms and now they are experiencing some of the biggest price busts. Reversion to the mean is a regular feature of housing markets and they are experiencing that now...

The housing news continues to be bleak for the financial actors who are holding mortgages, the value of which is tied to housing prices.  Continuing price declines probably mean that the banks will need even more bailout money. 

Yet, these declining prices aren’t all bad.  When prices fall, buyers get bargains.  One of the glories of America is that people are able to buy high quality houses at affordable prices.  We had lost some of that advantage during the unfortunate bubble, now we are getting it back. 

Yes, there's a bright side to falling real housing prices.  But falling nominal housing prices cause major institutional problems.  This is the phenomenon Irving Fisher called "debt-deflation" in the 1930s and identified as a major cause of the Great Depression: when the prices of assets that are used as collateral fall, the incentive-compatibility of loan contracts is destroyed.  That's why the Fed should not allow asset prices to rise so much.  The Fed should have choked off the housing bubble three or five or eight years ago with higher interest rates.  Now, however, it should do the opposite, and try to reflate housing prices-- nominal housing prices-- to something nearer their 2006 level, at the expense, if need be (and need probably will be) at the expense of fueling consumer price inflation. 

Fortunately this is sort of what the Fed is trying to do.  Monetary policy is by far the brightest spot in economic policy right now.  It's the one thing that definitely distinguishes the policy response today from that in 1929-33, when monetary policy was contractionary, and it's the main reason that this is not likely to be Great Depression II.  Most of the rest of what the government has done has been hapless at best and perverse at worst (the "stimulus," the Obama budget), and might just make this Great Depression II after all despite much better monetary policy.

Mr. Pork Apologist

"Obama defends pet projects, signs spending bill"

WASHINGTON – President Barack Obama, sounding weary of criticism over federal earmarks, defended Congress' pet projects Wednesday as he signed an "imperfect" $410 billion measure with thousands of examples. But he said the spending does need tighter restraint and listed guidelines to do it. Obama, accused of hypocrisy by Republicans for embracing billions of dollars of earmarks in the legislation, said they can be useful and noted that he has promised to curb, not eliminate them.

On another potentially controversial matter, the president also issued a "signing statement" with the bill, saying several of its provisions raised constitutional concerns and would be taken merely as suggestions. He has criticized President George W. Bush for often using such statements to claim the right to ignore portions of new laws, and on Monday he said his administration wouldn't follow those issued by Bush unless authorized by the new attorney general.

White House officials have accused Bush of using the statements to get around Congress in pursuing anti-terror tactics.

Obama signed the bill in private, unlike a number of recent signings that took place with fanfare, but he raised the issue of earmarks in public remarks playing down their scope and possible harm in the measure. They comprise about 1 percent of the spending package, which will keep the government running through September, he told reporters.

"Done right, earmarks have given legislators the opportunity to direct federal money to worthy projects that benefit people in their districts. And that's why I've opposed their outright elimination," he said.

Wow.  A grimly cynical comment about how fast Mr. Hope-and-Change has turned into Mr. Porkbarrel Spending Apologist would be almost superfluous at this point, as I suppose everyone knows by now what a travesty his campaign rhetoric was.  I wonder: Did Barack really defend earmarks on the campaign trail, or is he making that up?  Doesn't really matter, I guess.

The problem with earmarks is that pandering to handfuls of easily-mobilized swing voters in order to maximize the re-election odds of favored legislators corrupts the latter and is not conducive to efficient economic policy.  That's why earmarks are rightly unpopular, in the abstract.  But given the ease with which the sheeple can be bought off with cheap rhetoric, the Democrats may feel they run few risks by courting swing voters to the detriment of the general public interest.  And they may be right.  Such a large part of the population suffers, along with the media and intelligentsia, from Bush Derangement Syndrome, that if there's a run on the dollar people might convince themselves it's Bush's fault and Obamessiah was just a victim.

The pattern so far is that every time Obama does everything (since the Geithner appointment at least) the stock market drops.  Let's see if the pattern holds.

Dow Surges Back

"Stocks Post Best Rally of 2009 on Improved Citigroup Outlook" (Bloomberg)

March 10 (Bloomberg) -- Stocks around the world staged the biggest rally of the year after Citigroup Inc. said it was having its best quarter since 2007, spurring speculation the worst of the banking crisis is over. Treasuries and gold fell.

Citigroup jumped 38 percent as Chief Executive Officer Vikram Pandit wrote in an internal memorandum that the bank, which reported five straight quarterly losses, was profitable in the first two months of 2009. JPMorgan Chase & Co. climbed 23 percent and Bank of America Corp. surged 28 percent as Federal Reserve Chairman Ben S. Bernanke urged an overhaul of financial regulations. General Electric Co. rose 20 percent, its steepest advance since at least 1980.

“If we’re not at a bottom, we’re a pretty close,” said Michael Binger, Minneapolis-based fund manager at Thrivent Asset Management, which oversees about $60 billion. “It’s time to start putting money into stocks. Stocks are cheap and worldwide stimulus will eventually help lift earnings.”

The Standard & Poor’s 500 Index rebounded from a 12-year low, increasing 6.4 percent to 719.6 as all 10 industry groups rose more than 2.3 percent. The Dow Jones Industrial Average added 379.44 points, or 5.8 percent, to 6,926.49.

Wow.  That's great.  A stockmarket rebound encourages investment, by making capital more valuable, and investment is the key driver of the business cycle in normal times, though this one is very different in many ways.  That said, I suspect stock prices would have to rise quite a bit before firms would see a point in growing the capital stock.  Even with stocks pushing 14,000 investment was sluggish.  Meanwhile, here's a warning: "Ease Up on the Gas Pedal, Bernanke!"

Inflation is reigniting. The U.S. Bureau of Labor Statistics announced last week that consumer prices, which had declined from November and December, rose 0.4% between December and January, an inflation rate of 4.9% on an annualized basis. The bureau announced earlier that producer prices rose 0.8% in the same period, a 10% annual rate of inflation.

Why is this happening? The answer is painfully clear. From the end of January 2008 to the end of January 2009, the Federal Reserve's monetary liabilities, the sum of currency and bank reserves known as the "monetary base," more than doubled. This is a year-over-year expansion unprecedented in the Fed's history. During the last three months of that period alone, the base grew an incredible 50%. (At that pace, it would have quintupled in a year's time.) The base has thankfully receded a bit in February.

Broader measures of the money stock reflect the rapid growth in the base. The M1 measure (the sum of the public's currency and checking deposits) has grown at an annualized rate of 23% over the last six months, while the broader M2 measure has grown at 15%. As standard theory predicts, this rapid money growth has pushed short-term interest rates to historic lows. For the last 10 weeks 12-month Treasury bills have been trading at yields below 0.6%.

For perspective, flash back to the early years of the Great Depression. Between 1929 and 1932, runs on the banking system led to a sharp decline in the money stock, leading in turn to a general deflation. The best-known historians of the event, Milton Friedman and Anna J. Schwartz, faulted the Federal Reserve system for not using its money-creation powers to stop the decline.

In a 2002 speech at a conference honoring Milton Friedman on his 90th birthday, Ben Bernanke promised that the Fed would never again commit that error. Today, as chairman of the Fed, Bernanke is so eager to fulfill his promise that he is erring strongly on the side of monetary overexpansion.

Chairman Bernanke is quite right to want to avoid a collapse of the money stock, because when that happens, economic activity contracts needlessly. Certainly the Fed should not sit idly by while the money stock shrinks.

But today's money stock is not collapsing--not by a long shot. Moreover, while asset prices have fallen over the past year due to the bursting of real estate and stock market bubbles inflated by years of excessive money growth, the prices of consumer goods and services have not. The decline of asset prices thus does not represent a general deflation. Instead, it represents the correction of a relative price distortion. The reduction in asset prices is actually the beginning of recovery; thus, an effort to prop up asset prices delays recovery.

It's true that the decline of asset prices represents the correction of a price distortion.  But that correction could occur either by asset prices falling or by consumer prices rising.  If you have a $200,000 home that should be worth $100,000, the correction could occur through asset prices falling by half, or consumer prices doubling.  The latter is better.  Home-price deflation is disastrous because it creates a lot of deadbeat debtors, gives people an incentive to walk away from mortgages, and kills the banks.  Consumer price inflation is also bad, but probably less so.  A big inflation would be, in effect, a generalized partial debt amnesty, which is just what the country needs.  An inflationary five to ten years thereafter is a price worth paying.

If there is a recovery in the near term, the next question is whether Obama's stimulus worked, or whether it was a result of monetary policy by the Fed.  I'd bet on the latter.  I think-- very tentatively-- that Bernanke has been a bit too experimental in bailing out banks and buying private assets, but I've always thought his uber-easy money was the big bright spot in the US government's policy response to the crisis.

Here's Paul Krugman's rehash of Keynesian business cycle theory:

So, how does this all end?

I’ve been saying for a long time that this isn’t your father’s recession — it’s your grandfather’s recession. (I actually used the phrase about the last recession, too.) That is, it isn’t something like the 1981-82 recession, which was brought on by the Fed to control inflation, and ended when the Fed decided that we had suffered enough. Instead, it’s like the 1929-33 recession — or the recession of 1873-1879 — a slump brought on by the collapse of an investment and credit bubble...

Maybe it’s time to dust off Keynesian business cycle theory.

Keynes himself actually didn’t have much to do with this theory. In fact, one of the key moves in his development of the General Theory was the decision to focus on how economies stay stuck in depression for extended periods, rather than on the more complex question of explaining the economy’s ups and downs. But he did devote a brief chapter at the end to the subject, and Hicks elaborated on this quite a lot.

What’s notable about this theory is that it made no use of the self-correcting mechanism expounded in every principles textbook, mine included — the mechanism in which falling prices lead to a rising real money supply, which shifts the aggregate demand curve out moves the economy down the aggregate demand curve. Why? Well, as we’ve now learned the hard way, a sufficiently severe bubble-bursting pushes you into the liquidity trap, and makes the aggregate demand curve more or less vertical.

Instead, recovery comes because low investment eventually produces a backlog of desired capital stock, through use, delay, and obsolescence. And eventually this leads to an investment recovery, which is self-reinforcing.

And what do we mean by use, delay, etc.? Calculated Risk had a nice piece on auto sales, which I find helps me to think about this concretely. As CR pointed out, at current rates of sale it would take 23.9 years to replace the existing vehicle stock. Obviously, that won’t happen. Even if the desired number of vehicles doesn’t rise, people will start replacing vehicles that wear out (use), rust away (decay), or just are so much worse than newer models that they’re worth replacing to get the spiffy new features (obsolescence).

As autos go, so goes the capital stock. In the long run, we will have a spontaneous economic recovery, even if all current policy initiatives fail. On the other hand, in the long run …

Note the casual tone here.  That's not just Krugman's style.  It's essential to Keynesianism.  As became clear during the monetarist and new classical (rational expectations) counter-attacks in macroeconomics during the 1960s and 1970s, you can't make Keynesianism rigorous.  You can't base it on rational optimizing agents in competitive markets.  Keynes' original argument relied on various ad hoc behavioral and/or institutional assumptions, and was not always rigorous even when those assumptions are accepted.

Think about the argument here.  A "a backlog of desired capital stock?"  What does that mean?  Surely desire for capital (meaning capital goods, not money) is never in short supply.  I would be glad to have a house and a few cars and some functional machinery to make stuff with!  What limits people's willingness-to-pay (not their desire) for capital is that they expect the returns to be low.  "Obviously, that won't happen," writes Krugman about replacing the nation's stock of cars in 23.9 years.  No, that's not obvious.  If the economy deteriorates enough, we'll use our cars longer, and when they give out we might not replace them, just ride the bus or something.  Yes, the utility of cars rises as they become fewer, so there might be some pickup in demand as more of them fail, but that might just cause another drop in demand for something else (houses, say, or computers) as people cut other expenses to replace their cars.

Krugman diagnoses "an investment and credit bubble."  Something looks like a bubble if it pops.  That is, if variable x drops like a stone this year, x's level last year looks like a bubble.  But it might be, not that x was at an unsustainable level before, but that there was some shock, some disaster that caused it to fall.  Housing was a bubble, yes.  Credit -- maybe.  But investment, no.  First, investment, except residential construction, hasn't been so high for the past few years.  Second, the concept of an investment bubble is problematic.  It's clear what it means to say there's a bubble in, say, tulip bulbs: tulip bulbs are nonsensically expensive relative to other goods.  But investment is just a general term for all the stuff we make today that makes us richer tomorrow.  How can you have too much of that?

There's a much more parsimonious story to be told here.  A story that can be told in non-casual ways and make sense.  In the past few months, there's been an explosion of political risk, resulting in particular from the victory in the 2008 elections of Democrats who want to tax and spend more.  Investors have to think: If I invest, and succeed, how much of my returns will get confiscated by the state?  The answer to that question has just gotten a lot worse, ergo investment has fallen off a cliff.

UPDATE: By the way, for the record, I think Keynes might have been right that in 1936 what the economy needed was massive government spending.  The policy insanity of the 1930s had so devastated investor confidence that moderate measures and efforts to commit to non-expropriation couldn't work, at any rate not while FDR was president.  (If Wilkie had won in 1940, maybe.)  So having the lumbering government force the economy to move may have been the best we could do then.  And that's sort of what happened.  WWII was helpful because it forced a return to some kind of means-ends rationality: we had to make stuff and do things, even if it was just for the sake of killing rather than, say, the good life, and so we had to give doers and makers room and respect.  The 1930s cult of envy and escapism and paranoia withered and we became grown-ups again, and the habits of making and doing, combined with the Red Scare, brought a return of capitalism and prosperity (which WWII was not, despite high GDP numbers).  Keynes had one foot in theory and one foot in policymaking, and while I think the theoretical pretensions of the General Theory are hugely inflated and the biggest misstep in 20th-century economics was to buy into those pretensions, Keynes' advice may well have been largely right in an immediate sense.  Maybe Keynesianism can be compared to feudalism, which emerged during the 9th-century Viking invasions of Europe: it was a crude institution that may have been appropriate for a particular time, but whose continuance was unfortunate later.  Keynes was bad for economic theory but maybe good for economic policy, in the short run.  Today's Keynesian-revivalism, by contrast, is not theoretical improvisation to justify a sound policy hunch, but a bungling application of outworn economic doctrines that were invented for a very different economy, long ago.

UPDATE II: By the way, I was a little unfair above: the explosion of political risk began, not with Obama's and the Democrats' victory, but to some extent with the Bear Stearns bailout earlier this year, and especially with Hank Paulson's ultimatum last October.  Obviously these events were forced by markets to some extent, and there's no way for the authorities to "do nothing" in such cases (although they could have "done less"); since the state is the ultimate guarantor of the contracts of a bewildering web of which the big banks are at the center, it can't not be involved.  Paulson's ultimatum, in particular, was a breaking-point of sorts: I think prior to that moment no one had quite conceived that such a thing-- such a demand for authority, such volumes of money-- could occur.  Everyone's political model of what the government is and does vis-a-vis the market was thrown into chaos.  Obviously that's not Obama's "fault" even if he supported it.

But the handover of power in the wake of the Paulson bombshell was peculiarly unfortunate, because a revolution in the economic constitution was already underway and then was handed off into the extremely inexpert hands of Obama, and the hungry paleoliberal Democrats with their backlog of ancient agendas.  That Obama has capable lieutenants may be of little use.  What is needed is not advice but decisions, or rather, commitments.  Something to fix, and coordinate, expectations, to eliminate the sense of flux, the toxic counter-point of high-stakes grabbing and dreamy improvisation.