There is no Economic "Theory of Everything"

September 28, 2008 § 31 Comments

A complete economic theory of everything is not something which exists. Of existence, it has none.

Therefore, when we make economic choices, particularly in large scale crises with enormously complicated implications, we face the same kind of situation we face, well, pretty much all the rest of the time too. Even physics has no theory of everything, and in mathematics it has been proven that there is no such thing.

Our situation is as always that there are certain things we know, certain things we don’t know, and certain things we can’t know. The first we are responsible for; the second, we are responsible for learning to the extent it is important to our choices; the third, we simply have to trust to Providence.

Doing what is right right now, and trusting in Providence for the rest, is built into the nature of reality. We are always trying to banish our need to trust in Providence with our theories of everything. Thus far, our attempts to build the Tower of Babel have all been abject failures.

When we are in a burning train wreck in progress, and we have definite and clear means to get out and to rescue many others in the process, we have a concrete obligation to actually do so. If doing so violates our economic theories about actions and consequences that tells us something about our economic theories; it doesn’t tell us anything about our concrete moral obligations right here and now.

So color me unimpressed when it is suggested that the Chicago School is against the government injecting liquidity into the market to prevent a disastrous collapse with global implications. The last century or so is littered with the bodies of people who have suffered and even died for the sake of vindicating economic theories. “Let Main Street burn, because my economic theory tells me we should” is not a proposition I find it even slightly tempting to adopt.

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§ 31 Responses to There is no Economic "Theory of Everything"

  • Lydia McGrew says:

    Here: I haven’t even read more than a few paragraphs of this:http://tinyurl.com/3j23omNow, all I’ll say is this: These guys are not saying, “Oh, let’s all die for my theory. My theory is everything.” As I understand them, these guys are making a posteriori statements: This plan is bad. The bailout will make things worse in the long run. We should try such-and-such instead. The Great Depression scenarios aren’t going to happen. Etc. Not all of them are saying all of these things, but different ones are saying variants on different ones of these. They could be wrong. You could be wrong. I’m a man on the street with a strong instinct that government bailouts usually _are_ a bad idea, even if they are bailouts of all of us. I could be wrong, too. But I don’t think anybody should think that this is a matter of the High-falutin’ Theorists Who Care Nothing for Real People (economists who oppose the bailout–and there are a heck of a lot of them) vs. the Men Who Know the Real Facts (people in your position who consider it morally obligatory). Let’s face the fact that _everybody_ here cares about what’s best for real people. There are just apparently deep-dyed disagreements about what that is.

  • zippy says:

    <>But I don’t think anybody should think that this is a matter of the High-falutin’ Theorists Who Care Nothing for Real People (economists who oppose the bailout–and there are a heck of a lot of them) vs. the Men Who Know the Real Facts (people in your position who consider it morally obligatory)<>I may be wrong that the issue is largely polarized with hands on finance people on one side and economists on the other; but it sure looks that way.

  • Tomm says:

    But there are lots of people who oppose the plan who have nothing to do with high falutin economic theory. Many just feel that the gov. don’t know diddly squat about what will really happen with the buyout, and so should not feel so all-fired sure that THIS buyout will do the trick. The meltdown shows that the finance people who thought they knew what they were talking about 2 months ago didn’t, so why are they so sure they know now? I don’t actually agree with this point of view – I tend to think that some kind of a buyout is in fact the right way to go, as long as we can put together a plan that takes into account human nature. But their objection does carry some reasonable weight. My feeling is that any buyout package should be geared so that it does not have the long term effect of rewarding thoughtless, stupid, and basically greedy immoral behavior. To that end, anyone (investor or homeowner) who wants Uncle Sam to help him/her out should thereby lose whatever gain or equity they had been hoping to cash in on. Likewise with finance execs who made dumb investment choices – they should not only lose their not-yet paid bonuses, but to some extent retroactively lose the bonuses that were based on a false picture of the market 1 and 2 years ago.

  • zippy says:

    Tomm:I’m in basic agreement with your comment. I think what we have is a toxic mixture of perfectly appropriate Main Street skepticism coupled with a very real clear and present danger. Not a good combination. Academic economists throwing gas on the fire on the basis of their at best highly incomplete theories is not helping.

  • Anonymous says:

    Dang but you have a way with words! Very persuasive.

  • Anonymous says:

    If I have lots of money, I will go out and buy as many of these foreclosed properties as I can since the price is right. The previous owners have the choice to rent the property from me. I am not bailing these owners out, am I?If they hadn’t started out calling it a bailout, which gives the average person on the street the impression that all this money is being given away, then there would be more support. I think that once these institutions are in the control of the government, they can be reformed and they can be “leased” back to the previous owners. Just your average person on the street.

  • Clare Krishan says:

    But the properties are not the “assets” for a bank, they are the collateral that secures the “asset” = mortgage, the thing that earns money for the bank is the loan. (Take an accounting class to learn more). The bill gives us *nothing* as collateral: the originating Main St banks ‘sold’ the mortgages to investment banks in return for cash up front instead of waiting for the repayments over 15 years. The reason? A bank earns profits by creating “assets” ie loans, that earn more in interest than the bank pays as liabilities to the depositors (who expect a return on their savings, that’s why they’re called “laibilities” the bank “owes” that money to its depositors). Long term money is a low earner, so by trading the long-term assets for ready cash, the bank can leverage a lot more assets at much higher interest, pocketing vastely greater profits since liabilities have not increased at all (the depositor is happy with low earnings so long as his funds are safe). The problem is that leveraging only works so long as the borrower returns the funds lent out to the new owner of the stable of assets, the holder of the mortgage-backed security, which in some cases is the Communist Central Bank of China or the Kings’s private treasury in Saudi Arabia. The incentive to profit from interest spreads opportunities works so long as the value of the collateral equals or exceeds the value of the asset. However we’re assuming a rock-solid baseline, which we never had. The monetary units that value is exchanged in at market (mark to market) were being diluted as the Fed inflated the money supply. More, less valuable dollars began circulating in the global economy, what formerly could be bought for $10 now required $12, $14, even $20. The item’s value had not changed, but its price had. This gave the impression that the securities were magically “creating wealth” (when of course they were not). But the illusion was short-lived. Folks found that not only house prices climbed but ordinary cost of living expenses also, and as their discretionary income shrunk, they defaulted. The lender had no income to send to the owner of the mortgage-backed security and so the attractive safe investment value of the security was revealed to be not so safe after all, and those left holding them (the original owners sold them, bundled ’em, and resold ’em a number of times while the monetary supply was expanding) wanted rid of the contagion. Who to sell it to? At what price?Here is where we stand now. These financial instruments are worthless, since no buyers can be found at any price (its a free market, honestly, no one sees any value in them, since house prices are still falling so defaults are sure to increase)Thus what was a modest (perhaps non-performing) “asset” to a local Main Street bank has been leveraged (embezzled) into oblivion (but the pols and their Wall St associates would have us believe they “froze” rather than evaporated.) To avoid the deflationary shock of HONESTY, the traders in the derivatives (those with Communists and Kings as customers) have found a way out of their dilemma: perhaps enough dumb tax payers can be found to fix a price to this paper after all?Well you get to decide how dumb you want to be, but the fault lies with the expansion of the fiduciary media that incentivized the madness: no to the $700 bn and ABOLISH THE FED And Zippy there is an economic theory of everything: its called <>human free will<> to determine “value” by price discovery for goods in exchange:“All things are subject to the law of cause and effect. This great principle knows no exception, and we would search in vain in the realm of experience for an example to the contrary. Human progress has no tendency to cast it in doubt, but rather the effect of confirming it and of always further widening knowledge of the scope of its validity. Its continued and growing recognition is therefore closely linked to human progress.One’s own person, moreover, and any of its states are links in this great universal structure of relationships. It is impossible to conceive of a change of one’s person from one state to another in any way other than one subject to the law of causality.If, therefore, one passes from a state of need to a state in whichthe need is satisfied, sufficient causes for this change must exist.There must be forces in operation within one’s organism that remedythe disturbed state, or there must be external things acting upon it that by their nature are capable of producing the state we call satisfaction of our needs.Things that can be placed in a causal connection with the satisfactionof human needs we term useful things. If, however, we both recognize this causal connection, and have the power actually to direct the useful things to the satisfaction of our needs, we call them <>goods<>. If a thing is to become a good, or in other words, if it is to acquire goods-character, all four of the following prerequisites must be simultaneously present:1. A human need.2. Such properties as render the thing capable of being broughtinto a causal connection with the satisfaction of this need.3. Human knowledge of this causal connection.4. Command of the thing sufficient to direct it to the satisfactionof the need. Only when all four of these prerequisites are present simultaneously can a thing become a good.”Money is merely a “Measure of Price” and as the most economic form for storing exchangeable wealth (so long as those charged with the safekeeping of it do not expropriate the value for themselves, as the Fed/Treasury has done with the dollar) see http://mises.org/Books/Mengerprinciples.pdf

  • zippy says:

    The actual value of mortgage backed securities will depend ultimately on how many loans actually default, as your own account admits.<>And Zippy there is an economic theory of everything: its called human free will to determine “value” by price discovery for goods in exchange:<>Sorry, but that is just poppycock. In the long run, yes, markets do approximate real value, because you can’t fool Mother Nature; in the short run, markets are often quite irrational. This is manifest, though heretical in some economic congregations.

  • Anonymous says:

    Just wanted to mention that your “Interesting Quotes You Might Not See Elsewhere,” has actually appeared elsewhere–Bishop Fulton Sheen discussed that very concept in Life Is Worth Living–Just saying.

  • Danby says:

    I have been arguing against the bailout since it was proposed, not because I am opposed to a bailout <>per se<> but because this bailout is so extrememly self-serving and does not address the real problem the market is facing. The real problem is that the banks are holding a huge quantity of SIVs. which have dropped in value by as much as 50%. They have been using these papers as a cash substitute for reserve requirements. If they admit that the paper is not worth the face value, they are immediately (technically) bankrupt, and in violation of their reserve requirements. They can’t sell them off without lowering the price, and if they do that, they immediately have to discount all the SIVs on their books by as much as 50%.So what you have is a market in which the sellers cannot, for external reasons, sell their goods at a price that reflects their value. The banks need to recapitalize to get out from under this problem, but who will invest, <>knowing<> that the books are cooked? The bailout is an attempt to get Uncle Sucker to buy this paper <>at face value<> rather than based on what they are likely to actually bring in. $700bn is not enough money to do that. The real total is closer to $3tn. Some of that money would be recovered, but, contrary to the assertions of a great many, it will never be the face value.A better way out would be to do a “cram down”. That is, to wipe out the shareholders, and convert the existing bonds into equity. By converting the existing bond debt, the bank immediately recovers it’s reserve, and can then unload the SIVs at a realistic market price. This gives the bank an immediate advantage in the market, particularly for the issuance of new bonds.Some banks would likely not be able to survive even under this procedure, but they can be dealt with individually. At the very least, it puts the onus for a failed bank on the owners, and keeps the bank in business, without overloading the Treasury with worthless debt instruments.The current bailout proposal, especially the “mark to model” rule, are simply not going to actually work. It is more like piling more firewood on the bonfire.

  • zippy says:

    <>The bailout is an attempt to get Uncle Sucker to buy this paper at face value rather than based on what they are likely to actually bring in.<>That isn’t true. Nobody has suggested recovery of face value. The plan is to specifically assess and auction them to the government at hold to maturity value, not face value and not the current artificially depressed – because of liquidity – value.It is bizarre for people to (rationally enough) oppose mark-to-market on the one hand and (contradictory to the same liquidity premises) this plan on the other.An equity cram down might work, but not in time to save the credit system.

  • Danby says:

    That’s the point. The hold to maturity price is well above the amount of money these securities are actually worth. Right now, the bottom has dropped out of the CA real estate market. According to the impolde-o-meter website, the decline is as much as 40%. For many people holding the enormous loans, they are financially better off in the long term and in the short term, to just walk away from their mortgages. Some unknown number of them will do just that. When they do, What is backing up the paper? A piece of real estate worth, by the time foreclosure and recovery costs have been taken into account, less than half the outstanding principal.There would be a huge number of buyers for these securities at a 25% discount. That’s about what they’re really worth, because that’s what they will likely return. The hold to maturity price assumes no more defaults and no more foreclosures, which is just not reality under current circumstances. Whoever takes these papers will have to factor that unknown number of defaults into the price.This is why FNMA and FRMA had decided (just before being nationalized) to let defaults go for <>two years<> before foreclosing. Because each foreclosure drove down the value of their assets. The hold-to-maturity value is not the market value and not the real value. It’s a purely theoretical construct. Until the banks are forced to let go of that valuation, there cannot be any healing in the market.

  • e. says:

    “The real total is closer to $3tn.”This is the very amount that the United States had borrowed from the rest of the world since 2000 to pay for imported goods and service, trusting the strength of the U.S. economy then.Yet, what happened?American families took out loans for more debt than they could actually afford & corrupt barons went ahead and gave out loans to folks who could never pay it back!

  • zippy says:

    Danby:<>That’s the point. The hold to maturity price is well above the amount of money these securities are actually worth.<>When you first commented, you claimed that the plan called for the government to buy the securities at face value. That is just outright false. Now you seem to be playing games with the concept of hold-to-maturity value. Unless I am mistaken, hold to maturity value is by definition the amount of cash that the security will actually produce for the holder over its lifetime, discounted for the cost of money. IOW, the hold to maturity value is by definition what the securities are actually worth.Maybe what you mean is that you don’t trust Paulson and the oversight committee to do a good job figuring out their hold to maturity value and buying them at an appropriate price. Maybe you mean to say that you think figuring out the hold to maturity value is very difficult, and you expect them to be wildly optimistic in doing so. Those are perfectly legitimate concerns, but you shouldn’t dress them up as an objection to the plan, when what they really are is an objection that you don’t expect the plan to be carried out competently.

  • Danby says:

    Okay, I used face value as a shorthand for the hold-to-maturity value, figuring more people would understand the concept.Hold-to-maturity value is a subjective judgment. It can be modeled, but the end number is extremely subject to assumptions made in the process. If the securities were actually worth what the banks claim they are, they would have no trouble selling them. I am claiming that Paulson has been playing games with the value of these securities for the last 5 years, and even before he left his extremely lucrative position at the helm of Goldman Sachs. I have no reason to believe he will be honest in his valuations. Markets, when provided with sufficient information, force a level of honesty. Government fiat does not.In other words, the market already is capable of valuing these securities. What is the 700bn besides desperate attempt to prevent that valuation from occurring? If anybody really believed these securities were worth the “hold-to-maturity” value, they would be offering that price for them. There’s plenty of money in the securities market ready to jump on any good long-term investment. No-one wants them at that price, because that price does not reflect the actual value. The “hold-to-maturity” price is a made-up number, and nobody, not even Paulson, believes it.It’s not that I don’t expect the plan to be carried out competently, it’s that the plan is a smoke screen. That’s why it was considered important to put in the “no review” clause, so that nobody could stop the process when it became clear that the whole plan was just a step short of criminal fraud.

  • zippy says:

    OK, that’s better. <>In other words, the market already is capable of valuing these securities.<>Hidden in here seems to be an assumption that short term market prices of very complex instruments are always rational. Not a good assumption, at all. It is definitely not true in this case. Traders will tell you that they will not bid for these <>because they don’t know how to value them<>, not because they have no value. When floor traders and workaday analysts don’t know how to value a security, the trading value of that security goes to nothing. Also, I discussed the issue of scale and transparency over at What’s Wrong with the World. The market is <>not<> capable of properly valuing these securities, it had assumed that the rating agencies had done so competently, and that is precisely the problem.I completely understand the jaundiced eye taken here. But stop and consider for a moment what Paulson could have done had he simply had a big givaway to his Wall Street pals and profiteering in mind: he could have proposed an insurance scheme just like the one the Republicans proposed. That would separate losses from gains and place <>all<> of the losses on the taxpayer, keeping <>all<> of the gains with the institutions holding the paper. It would look like a much smaller number in terms of allocation, so it would be an easier sell by far. It probably could have gotten bipartisan support much more easily than this monster. Granted, it probably would not be quite as effective as actually taking these securities off the table outright in terms of heading off a real credit freeze; but it would still be far better than doing nothing in that respect.Finally, much as people quite rightly disparage Goldman Sachs for not caring a whit for anything but returns, they care a whole lot about fiduciary duty: that is, they don’t much care who loses as long as the investors whose money they are investing win. Paulson’s ‘investors’ right now are the taxpayers, and I find it perfectly believable that Goldman’s ruthless attitude toward fiduciary duty is still with him in his government post. Otherwise I don’t know why he would have tried to do the difficult thing here rather than the easy thing. One thing he is most definitely <>not<> is financially stupid.Heck, even “once you turn the money over to me, I’m in charge and I’ll make you a killing” is typical Goldman.Mind you, it isn’t crazy to distrust pretty much all of the people involved. Someone is going to manage our funds, though, and we could do a heckuva lot worse than to have Paulson doing it.

  • Danby says:

    I would never accuse Paulson of being stupid. A man can’t get to the top of an organization like GS if he’s not one of the smartest of a very smart group. What I do see is that the people like Paulson, who actually run this economy don’t know <>what<> to do. They’re making it up as they go along. The bailouts keep getting bigger, but the problem only intensifies with each iteration. Given the way this has worked over the last few weeks, I would expect the bailout, if passed, to prop up the markets just long enough to get past the election, which may be all that Paulson and the administration care about.I agree with you that something needs to be done, and soon, but doing the wrong thing is worse than inaction. If, for instance, the Treasury is unable to borrow the 700bn at a reasonable rate, it will have to be printed. That runs the risk of serious inflation (though not the hyperinflation that some suggest) still, I can remember the 10% inflation of the 1970’s and I don’t think that would be good for anyone either.Simply put, we’re going to have a serious recession whatever the guys in DC and NY do. I think it’s a good bet that the bailout bill could shove us over into a depression, because it doesn’t really address any of the problems of systemic dishonesty in the financial markets. Part of that is the insane complexity of these securities, which were formulated that way specifically to make the bad debt invisible to the person who buys the paper.The other real problem we have is that the practice of “naked shorting” is capable of actually pushing a firm over into collapse. It should be a crime, and I’m not sure why it’s not.

  • zippy says:

    <>They’re making it up as they go along.<>That may or may not be true in general, but it isn’t true here. These specific complex illiquid securities are precisely what is gumming up the credit system; taking them out and replacing them with liquid T-bills quite directly addresses the credit issue specifically, at minimum cost. You yourself pointed out that Paulson is as expert on these things as anyone on earth, and we’ve known for years now that they are a problem, though not how bad it would get. I doubt he made up the ‘nuclear option’ on the fly; “buy them all up” has probably been in his mind as his ‘nuclear option’ for credit armageddon for some time. Goldman guys don’t zip their pants without a plan and four contingency options.There may well be capitalization issues beyond the credit clog, of course, though consolidation may take care of that.<>If, for instance, the Treasury is unable to borrow the 700bn at a reasonable rate, it will have to be printed.<>Pshaw. There is <>tremendous<> demand for T-bills right now, to the extent that investors are accepting zero coupon in order to get into them. It is inherent to the problem that T-bills are very strong. They are better than cash, because ‘cash’ is often a euphemism for the “liquid” holdings of the institution holding it for you.<>Simply put, we’re going to have a serious recession whatever the guys in DC and NY do.<>I agree with that. This isn’t a cure-all for the economy as a whole, it is specific targeted medicine – medicine at that, not a cure – for a specific malady in the financial system specifically which will kill the economy if it doesn’t get addressed. Stents keep the heart beating and the blood flowing, they don’t make the patient perfectly healthy in every respect.

  • Anonymous says:

    Are you concerned about the (continuing) transfer of power from the legislative branch to the executive branch, in this case via cabinent appointees, beginning with Paulson but ending with…?

  • zippy says:

    There are a lot of things I’m concerned about politically; but Congress establishing a fund to buy up troubled assets, and appointing the Treasury Secretary to do it, is not one of them. It is precisely how things are supposed to work: the legislative branch makes the laws, and the executive branch carries them out.

  • e. says:

    Zippy,“These specific complex illiquid securities are precisely what is gumming up the credit system”You are overlooking that this is not merely a problem of Illiquidity, but also one of Insolvency.Merely swapping the toxic assets for good ones won't, by itself, free up the Credit Markets since there is also the latter issue, which requires Capital — as I've been reiterating time & again.– e.

  • zippy says:

    e:Not to play the market hawk here, but I’m not convinced that intervention is necessary to resolve the capitalization problem, which really <>is<> more of a Wall Street problem than a Main Street problem at this point. I think there is hope for consolidation and other market mechanisms to provide a resolution there: look at the Wells fargo play to eat Citi’s lunch – a Wachovia sandwich – today. The capitalization problem is separate from the liquidity problem.But a locked up credit system will kill the economy.As I’ve said many times, this remedy is targeted at specifically the liquidity problem in the financial system which will kill the economy if not addressed, and at specifically a key underlying cause of the liquidity problem. Yes, there are doubtless other problems. So what? It is ridiculous to criticize a doctor for taking a tumor out of a patient who also has a heart problem.A lot of additional damage has been done by the ignorant delays. Hopefully not irreversible damage.

  • e. says:

    Zippy,It’s all moot now since the House has just passed it.“A lot of additional damage has been done by the ignorant delays.”Not really — the first bill was awful (not that this one was any better).As one economist put it very well, if the crisis were like a boat on water with a hole in it; the first bailout bill solely focussed on saving the boat with the hole in it without even trying to fix the hole itself.However, we can argue <>ad inifinitum<>.The Fate is Now Sealed — be it good or no.

  • Anonymous says:

    I’ve heard that Democrats are furious about being painted into a corner by free-spending Republicans (not just the bailout, but the Iraq War) and that rather than bus the budget they are simply going to start nationalizing industries, and this bailout sets a precedent. What do you say?

  • zippy says:

    It is a perfectly valid worry. The left wing of the Democratic party will nationalize everything they can, with or without an excuse. That is part of why I supported the original Paulson plan and not the equity participation which was added later. Of all the recent government actions and proposals, the original Paulson plan was just a pure play government buy up of a certain kind of securities — securities which do not represent an equity interest in any corporation. Understand that it is a damned if you do, damned if you don’t situation: if the credit system actually locks up, we’ll get nationalization good and hard, and worse besides.

  • e. says:

    Zippy,Your prediction rang true:“…if the credit system actually locks up, we’ll get nationalization good and hard, and worse besides.”BREAKING NEWS: U.S. will buy stock in financial institutions, Treasury Secretary Paulson says

  • Lydia McGrew says:

    But that was what the B.O. was supposed to _prevent_.Btw, is there a coincidence in the fact that this is almost word-for-word the same as a comment put up by Aristocles, just a few hours ago, at W4?

  • zippy says:

    There has long been a correlation in style between comments here and there.<>But that was what the B.O. was supposed to _prevent_.<>I don’t know what the referent of “that” is supposed to be.

  • Lydia McGrew says:

    Getting socialism good and hard.

  • Lydia McGrew says:

    Thanks for the confirmation on the similarity of style, too, Zippy. I’ve just wondered before but haven’t gathered data systematically. There are also divergences of style, so I remain partially agnostic but leaning.

  • zippy says:

    Ah. Well, clearly it isn’t a binary proposition. It is (always was) going to be bad, it is just a question of how bad; and the worse it gets, the more socialism we’ll get.You can at least take some small comfort from the fact that these are specifically non-voting preferred shares, so they should keep the government out of the day to day business of running the bank — well, at least as an equity holder, though of course not as regulator. Paulson really does seem to be making an earnest effort to achieve “as much free market as possible”, if you will.

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