Canadian Cincinnatus

European austerity is the wrong answer to Europe’s problems

As a small government conservative, I might be expected to champion government austerity wherever I find it. However, this is not the case. For instance, I am greatly opposed to the European-style austerity programs that are being foisted upon Greece and Spain.

But isn’t government austerity good, the fiscal equivalent of cod liver oil? Depends on what you mean by austerity. In Europe, austerity doesn’t just mean cutbacks in government spending. It also means tax increases, particularly on the wealthy. Do you still like austerity - European-style?

The reason such a program cannot work is that the biggest factor determining the state of a government’s budget is economic growth. The reason is twofold: the government’s principal source of revenue is income tax, which declines in a recession; and its biggest expenditure is welfare spending, which skyrockets in a downturn. For this reason, an economic slowdown negatively impacts government revenues and outlays at the same time. In contrast, economic growth positively impacts both items at the same time. Therefore, an economic plan that does not stimulate growth will not work well.

Unfortunately, thanks to steep tax hikes for job creators, European austerity plans are not neutral with regard to economic growth. These plans are job killers - and growth killers. Therefore, while the spending cuts will help the government bottom line, the tax increases will throw more people out of work and cut government revenues even more – negating the positive effects of the cuts. With pain increasing both on the job market and the welfare office, the country finds itself in a death spiral, with government cuts chasing lost government revenues.

This can be seen in the US federal budget since the 2008 meltdown. As I mentioned a year ago. 

Much of the current deficit is caused by a combination of a loss of income tax revenue corresponding with an increase in social spending due to the Great Recession. Medicare, AFDC, Section 8 vouchers, food stamps, unemployment insurance: all of these programs have grown by 50% or more in the past 3 years.

As much as we conservatives like to think, Obama’s big spending initiatives have not been the biggest factor propelling the trillion dollar US deficits. It is social spending, caused by the recession. Grow the economy and these budget-busting items will shrivel all on their own – as revenue rises!

This is why I am also opposed to the IMF. They push the European brand of austerity to any troubled country that will listen to them. Fortunately, countries that turn down their strings-attached loans invariably do better.

Indeed. If you look at history, there are basically only two ways that governments have ever dealt with a crippling debt load. The first is to default. The second is to modestly reduce government spending, keeping discretionary expenditures constant in absolute terms for a number of years, while growing the economy so that tax revenues increase as social spending declines. These are the only two realistic choices. European-style austerity is not an option, at least not one that has ever worked in the past.

 

The Democrat’s war on low prices

Economists Iain Murray and David Bier make the following case about ivory tower intellectuals and other Democratic elitists:

“What is to blame for Americans' economic woes? Why, Americans' selfish desires, according to a school of thought that appears to be currently dominant in the White House. An excellent example of this line of thinking is former presidential economic advisor Robert Reich's recent article in the Financial Times, in which he claims America's ‘insatiable consumers’ have destroyed the economy and the ‘hubs of our communities’ with their relentless pursuit of ‘great deals.’ The ‘lure of the bargain,’ suggests Reich, is a destructive force.

Well that's rich -- Berkeley professor Reich, clearly a member of the 1 percent, attacking the 99. While Reich consider low prices a great evil, he ignores what they actually mean. Low prices indicate that a good or service has become more abundant -- that is, more available. This availability of goods and services is the very definition prosperity. The pursuit of low prices, which so offends Reich, is just the pursuit of prosperity -- the pursuit of happiness that the Declaration of Independence called ‘unalienable.’" 

“It's easy for rich liberals to ask for higher taxes and higher prices, but these policies dramatically damage Americans' standard of living. President Obama's cap and trade bill would have cost each American family $1,761 per year, according to the White House's own figures. While that bill failed, Obama's anti-drilling, anti-pipeline, anti-energy agenda is already forcing Americans to spend more on gas as a percentage of their income last year than at any point in the last three decades. Higher prices can and do kill the American dream.”

“Low prices mean abundance and prosperity. High prices mean scarcity and privation. The dynamic capitalism that works to drive prices ever lower has helped make America the most prosperous nation on Earth. The high price economy the Obama administration and its supporters want will benefit no one -- except, ironically, some of the 1 percent.”

This hostility to bargains is certainly not confined to the White House or to energy policy. Witness the widespread hostility to Wal-Mart and indeed any other store (usually a nationwide chain) that features low prices. How much respect does Ronald McDonald get? And what do the liberals like instead? Why boutique specialty stores and farmer’s markets: upscale places with the highest prices where poor people cannot be seen, except among the help. Molson’s and Coors bad, yuppie brew pubs good!

In reality, Wal-Mart has done far more for the plight of poor people in North America than all the bleeding heart, do-gooders combined. All the latter have to offer is moral preening and handouts – i.e. more dependency. Wal-Mart offers them something rich latte liberals can barely comprehend: a break on their grocery bill.

Of course, if socialism actually produced wealth instead of misery, then you wouldn’t hear a peep about concepts like ‘sustainable living’. Instead, leftists would be saying things like: “Look comrades, hot and cold running water! Ivan never had it so good.”

But socialism doesn’t produce prosperity. It produces misery, so all the socialists have left is to denigrate the prosperity that capitalism produces and that the real ‘proletariat’ enjoys.

 

The best explanation of the EU follies I have yet read

Every time I hear that EU officials are preparing yet another bailout, bigger than the previous one, to save the Euro, I shake my head. The more good money they throw after bad, the worse the Eurocrats are making the crash when it finally does come. How do I know a crash is coming? Simple. When too much bad debt accumulates, the free market’s natural healing mechanism is bankruptcy. The more bailout money countries like Greece get, the more they waste and the more exposed previously solvent banks become; and the bigger the next bailout needs to be. Clearly, instability in the system is increasing. At some point it has to stop. I think the operating principle of the Eurocrats is fear: fear of the bust. Their answer: to kick the can down the road far enough that Something Happens to fix it.

Richard Fernandez of the Belmont Club, riffing off Nassim Taleb (who has an article in Foreign Affairs on why the US didn’t see the Arab Spring in Cairo coming), offers the best theoretical explanation of why overcentralized bureaucracies cannot foresee (let alone control) Black Swan events:

“The elites won’t see them coming rather than that they can’t. Part of the problem is the consequence of their own damping. By attempting to centrally manage systems according to some predetermined scheme they actually store up volatility rather than dispersing it. By kicking the can down the road they eventually condemn themselves to bumping into a giant pile of cans when they run out of road.”

Taleb here: 

“Complex systems that have artificially suppressed volatility tend to become extremely fragile, while at the same time exhibiting no visible risks. In fact, they tend to be too calm and exhibit minimal variability as silent risks accumulate beneath the surface. Although the stated intention of political leaders and economic policymakers is to stabilize the system by inhibiting fluctuations, the result tends to be the opposite.”

Back to Fernandez:

“Thus every bailout and rescue made in the name of preventing the demise of something deemed “too big to fail” builds up a head of steam until the point is reached when the system can no longer contain the pressure. Then the volatility goes from a seeming zero to an extremely high number. The Black Swan will have arrived. And it always will for as long as fiction is substituted for fact, failure is relentlessly reinforced and false assurances are given all around.”

“Given the fact that politicians and economic managers are elected or promoted for their skill at “controlling events,” they can hardly admit that they cannot. It will take an intellectual revolution to make everyone realize that human control over the real world is really limited. And yet accepting that volatility must be faced rather than hidden is the key to preventing the arrival of even more Black Swans.”

The answer to this problem is decentralization:

“The key difference between a central manager and more localized management is that the local managers do not feel compelled to a create a grand unified theory of events. They do not have an incentive to keep stories consistent with the overall narrative. They have no talking points from which to stray. They only have problems, which they more or less try to solve.

There is a positive correlation between the degree of centralization and the required amount of “smoothing” that the headquarters will demand. Localized response can deal with variation. Huge central planning organizations cannot. And it is in the differences — it is in the outliers — where the significant information lies. When everything has been smoothed out to conform to the 5 Year Central Plan, then Taleb argues, all the real information has been simultaneously purged.”

I think this is about right. The economy is a complex adaptive system. It’s too complicated to control. Indeed, left on its own, it will find its optimal solution. Central control only gets in the way of the uncountable feedback mechanisms built into the marketplace. All the central planners end up doing is to cause the imbalances to unnaturally accumulate even more.

Fernandez then adds this interesting point I hadn’t even thought of:

“One might add that advances in IT itself have contributed to this problem.  With the advent of computer networks, databases and intelligence fusion came not real control but to a large extent, only the illusion of control.  IT did not in fact allow the elites to eliminate Black Swans. What it did was enable them to hatch very large ones.”

Democracy, real democracy - like the referendum that Greece proposed over its bailout (but which was subsequently squelched by the EUrocrats) - is part of the answer to the problem of the technocratic elite: 

“When E. E. Schattschneider said, “Democracy is not to be found in the parties but between the parties,” he was on to something. It is not that either party has the truth, but simply that a debate between any two genuinely opposed sides facilitates the emergence of the truth, even as a byproduct. This is a clue to why freedom works. It prevents the emergence of a single authoritative dogma, which left to itself would ruthlessly exterminate all other points of view, the truth in especial, if it were inconvenient.”

 

Fortune Magazine: “Europe should embrace failure”

Daryl Jones, in Fortune magazine argues that the way out of Europe’s debt crisis is for indebted banks and countries to be allowed to fail: 

“Failure is not a bad thing. Sure, losing or failing doesn't give you the warm fuzzies inside, but failing and adapting ultimately sets you up for greater success.”

“As it relates to Europe sovereign debt, the one solution that has not been seriously considered is failure. Instead, the key solution from almost every Eurocrat and talking head, is to continue to support and promote a broken banking system and failed monetary union. There are other possibilities: let Greece fail, let other sovereigns fail if they can't get their house in order, and let heavily exposed banks fail.

The validation of the failure strategy at least partially comes in comparing the credit default swaps of Italy, Portugal and Ireland from July 1, 2011 to today. Respectively, Italian swaps are up 140%, Portuguese up 38.2%, and Irish down 3.2%. Now to be fair, Ireland hasn't failed, but three of its largest banks, Allied Irish, Irish Life & Permanent, and Bank of Ireland have experienced ‘credit events’ and, as a result, Ireland's credit worthiness has improved, on the margin.”

Add to Ireland my homeland of Estonia. It had a massive real estate bubble that burst in 2008. But because the country is so small and unimportant, it received no bail-out, everything was allowed to fail that couldn’t survive on its own, and as a result, it currently has the highest growth rate in Europe – 8.2% - with the only budget surplus of any EU government. Another example is Iceland. Early on in the crisis you heard a lot about it and its credit bubble. But because it wasn’t plugged into the Euro, nobody bailed Iceland out. As a result, what needed to fail, failed and Iceland is now doing fine.

A counterexample is Japan, which is has been stagnating for almost two decades after its real estate bubble burst. Why is it stagnating? Because nothing has been allowed to go under. Zombie banks lumber on like Frankenstein’s monster, kept alive by the IV drip of Keynesian spending. Oh yeah... Japan has racked up a public debt to GDP ratio of almost 200%.

I think because it is a painful thing, the regenerative powers of bankruptcy are often underestimated. Bankruptcy has an important role to play in the marketplace, particularly in helping an economy recover from a crash. One key ingredient in any economy is capital. How healthy an economy is, is determined at least partially by how well capital is allocated. Crashes often happen because of capital misallocation. Think of all the money sunk into subprime mortgages in the US. The money sitting in these mortgages was unproductive because a large percentage of the people who took out those mortgages had no hope of paying them back. The Eurozone equivalent of the subprime mortgage is the Greek government. Money sitting in Greek bonds is simply wasted because it could be better spent on other things.

How do you get out of this problem? The first rule of getting out of a hole is to stopping digging it deeper. When Germany approved a 350 billion Euro bailout to Greece earlier this summer, that meant 350 billion more Euros are now unavailable for productive investments. What could be accomplished with 350 billion Euros? I bet Steve Jobs would have had some interesting ideas.

One of the advantages of a crash-induced wave of bankruptcies is that it resets the bad debt counters to zero. People with subprime mortgages have no home; people who own Greek debt or Lehman Brothers stock or GM stock get a haricut. But the flip side is that money is only an indicator of wealth. It is not wealth itself. All that has happened is that the monetary value of individuals and corporations has now been better matched with their actual worth. The information content of money has increased because money becomes more correlated with value. Thus investments can be made more intelligently. 

Except when everything that should fail is bailed out. When governments prop up teetering enterprises and failing governments, the transfer of wealth from productive activities to unproductive activities accelerates and the information content of money degrades further. Thrifty and productive Germans get poorer while the lumbering Greek leviathan consumes ever more resources; productive American citizens (and American citizens not yet born) get hobbled by yet more government debt in order to keep wealth-consuming Wall Street zombie banks staggering along. As the productive are increasingly hobbled - so are the unproductive, who are trapped in a spiral of onerous debt repayments. The result is universal stagnation.

In Obama’s America… and in Eutopia… and in Japan. 

 

The Democrats are right about the debt crisis, but only in ways that undermine their basic governing philosophy

Democrats like to scoff at conservatives when we say lower tax rates can increase tax revenues. Conservatives like to point to the Laffer curve, which states that government revenues can go up when tax rates go down. Unfortunately, what conservatives don’t acknowledge (or are unaware of) is that the more politically popular a tax cut is, the less it stimulates the economy. To get people hiring again, you need to cut the tax rate of employers. And who are they? Mostly, they are the ‘millionaires and billionaires’ who make over $250K a year - to use Obama’s terminology. In other words, the Laffer curve is right, but only when it comes to tax cuts for rich people, corporations (the US has one of the highest corporate tax rates in the developed world), investors and savers.

Why don’t middle class income tax cuts do much? Because the middle class doesn’t do much hiring. They might spend a bit more but that isn’t particularly advantageous because they spend too much anyway, judging by the consumer debt load the average American carries.

Another thing: for a tax rate to be stimulative, it must be permanent. Hiring decisions are made on the basis of long-term planning, which are only affected by long-term tax rates. The temporary Bush tax cuts are nowhere near as stimulative as they would have been if they had been permanent from the start. That is why they failed to boost federal revenue.

Therefore, for a Republican tax cut program to bring in more revenue, the GOP must not pander the public with populist moves. They must attack the antibusiness rhetoric of Obama head on. There is no other choice.

Another thing the Democrats are partly right about is that when they say the deficit is caused by the Recession’s lower tax revenue not Obama’s spending, they are 50% correct. Though while spending soared under Obama, tax revenues have cratered. The graph below illustrates this.

But what is the best way increase tax revenue? By taxing the millionaires and billionaires who do the bulk of the hiring? No. That will drive even more people onto the unemployment line, increasing government spending even more. Much of the increased spending in the past two years has been due to government aid to the poor. A record 44 million Americans are now on food stamps. Medicaid, food stamps, section 8 vouchers and other welfare-based entitlement programs have all increased by over 50% in the past two years. These have been the real drivers of spending growth, not Social Security or Medicare (these middle class entitlements have increased by only 7% and 6% per year respectively). As Arthur Laffer himself pointed out, you can’t balance the budget on the back of the unemployed.

To increase tax revenues, you must grow the economy with pro-growth policies such as tax cuts on savings and work, as well as removing restrictions on work and savings through deregulation. Do that and tax revenues will swell while spending on those burgeoning welfare entitlement programs will simultaneously shrink as people will go back to work. Interestingly enough, Obamacare hasn’t been a big contributor to the deficit yet. That fiscal hurricane hasn’t made landfall yet. The treasury busting entitlements have all been in place since the New Deal and the Great Society.

Of course, none of this is to suggest that cutting discretionary federal spending back to 2008 levels (or for that matter to 2002 levels) is a bad idea. It is not. It is a very good idea. Ultimately, the budget can’t be balanced without serious cuts in discretionary programs. It is just that such cuts cannot by themselves solve America’s fiscal problem. The $1.5 trillion deficit is just too big for that.

 

How to resurrect America’s inner cities: create jobs poor people can do

Walter Russell Mead is a professor of Foreign Affairs and Humanities at Bard College. Recently, at the American Interest, he wrote an essay on what is wrong with America’s blighted inner cities and how to correct the problem. It is a must read. A few selections to wet the appetite are reproduced here:

“We need to stop thinking about our inner city problems so heavily in terms of race.”

 “The first and most important precondition for returning health to poor urban neighborhoods is the creation of large numbers of private sector jobs that relatively unskilled people can do.”

“So where will the jobs come from?

Answer: if they come at all they will come from small business and many of these jobs will not be particularly attractive.

Businesses that hire low skilled workers without much experience or with checkered work histories are often smelly and noxious.  They are unlikely to pay particularly well.  There will be lots of casual day labor involved with not many benefits — and perhaps little information sent to the IRS.  Casual construction work and small repair shops where people bang metal and use power tools all day long are the kinds of employers we need in the inner city.  Working conditions are not always great — and these industries do not always attract the most humanitarian and generous people on earth.  The factories that hired illiterate and unskilled urban workers 100 years ago were offensive from many points of view;  they did, however, actually hire those workers and put tens of millions of people on the thorny, difficult and uphill path toward middle class life.

Think of the path to successful middle class living as a ladder; the lower rungs on that ladder are not nice places to be, but if those rungs don’t exist, nobody can climb.  When politicians talk about creating jobs, they always talk about creating ‘good’ jobs.  That is all very well, but unless there are bad jobs and lots of them, people in the inner cities will have a hard time getting on the ladder at all, much less climbing into the middle class.”

“Many sensitive and idealistic people in our society work very hard to keep from connecting these dots and admitting to themselves that bad jobs are something we need.”

“To get these jobs, we have to change the way our cities work.  Essentially, we have created urban environments in which the kind of enterprises that often hire the poor — low margin, poorly capitalized, noisy, smelly, dirty, informally managed without a long paper trail — can’t exist.  The kind of metal bashing repair shops that fill the cities of the developing world are almost impossible to operate here.  Plumbers, carpenters, electricians, pushcart vendors and day care operators need licenses; construction work has to comply with elaborate guidelines and city bureaucracies disgorge the required permits slowly and reluctantly.”

“The bien-pensant gentry politics that dominates political discussion in respectable circles has lost touch with the realities of American life and no longer really comprehends the issues at stake.”

“’Progressive’ policy now increasingly means policy that benefits genteel upper middle class liberals and public sector government workers; the resulting mix of complex and poorly applied regulations, high costs and high taxes throttles the only kind of job creation that could offer most inner city residents a feasible step up.”

“Without rapid, small business led growth, there is no way that the residents of our inner cities can escape the cycle of poverty that has them in its grip.  And progressive blue politics as conventionally understood systematically squeeze and crush growth in our cities.  The bluer a city, the bluer a state, the fewer private sector jobs it tends to create.

Until our urban leaders grasp these truths, conditions in the inner city will continue to go downhill as more and more cities start to look more and more like Detroit.”

Though the essay is long, it is well worth reading the whole thing. There are many interesting points that I didn’t quote for reasons of brevity.

I have only one thing to add to Mead’s essay and it is in the form of a personal anecdote. I have a friend who owns an auto body shop within the City of Toronto. In his shop can be found a paint booth. He tells me that auto body paint booths are now illegal in the City of Toronto even though Toronto is home to over a million cars, which is why auto body shops line the streets of Vaughn, immediately to the north of Toronto. His booth exists only because it was grandfathered at the time of the ban. But if he were to sell his shop, the new owner would have a mere 48 hours to get the spray booth up and running again or he would lose its grandfathered status.

Mead is living proof that not all academics are one dimensional, second rate, left-wing propagandists. We need more professors like him.

 

Iceland shows the way out of a financial meltdown: the government should do nothing

Iceland was one of the countries that was hit hardest by the Great Recession but since then, it seems to have recovered well. What did it do? Let's find out…

"Iceland didn’t rescue its banks.  It couldn’t afford to do it.  So, they went bust. Iceland looked like it was going down a path of permanent financial armageddon. However, Iceland is in better financial shape than the rest of Europe today.

'Europe’s bailout path has only diverted ever-more resources to failing enterprises, postponing and deepening the problem. Iceland’s restructuring was both painful and costly for the population, but the government did not throw good money after bad, and the taxpayers were spared a nationalization of private debts. Is it any wonder that forward-looking financial markets are now betting on the Icelandic recovery?'

No Dodd-Frank. No super heroics. Just a level headed, clear eyed administration of bankruptcy law."

This reminds me of the depression of 1920, which many say was more severe than the Great Depression, even though it lasted barely a year. The President at that time, Warren Harding (the one professional historians always place near the bottom of great President rankings), approached that crisis with the same laissez faire policy of today’s Icelanders. As a result, the depression ended just as quickly.

The lesson for Obama here is that if you don’t know your history, you are doomed to repeat it.

 

It’s regulations - not labour costs - that are killing the US manufacturing sector

Read this article in the American Spectator, written by an entrepreneur who contrasts the regulatory burden faced by an upstart manufacturer in America and in China. For instance, he says:

“Today the environment for starting and operating a manufacturing plant is not good. Gone are the days of "Great, go to it, do the best you can." Replaced by, "NIMBY" -- Not In My Back Yard. The government has imposed itself as our costly overseer, placing environmental, zoning, and wage/benefit restrictions so burdensome in time and cost that businesses are left barely competitive if not impossible to begin.”

He goes on to describe all the regulatory hurdles, burdens and risks he faced while trying to set up a manufacturing plant in a north-eastern US state. The list is long so I won’t repeat it here. In contrast, this is the regulatory procedure he faced while starting up a manufacturing plant in China:

“Now, consider my experience the last time I visited China. I was escorted by the governor of Tianjin State to one of his new cities and shown the process to open a manufacturing facility. I was led into a room with a series of desks. You start at the first desk where you present your plan. Thereafter you proceed from one to the next obtaining approvals or agree to modifications on the spot until at the last table where you are shown what lots and buildings are available that best suit your needs and the price of each. The total timeline for permits, from beginning to approval, takes about 3 hours.”

“Now, this is China so the government and the state share 30% of your business, but considering the ease of entry, increased in-country sales and helpful attitude, this is a small price to pay, especially considering America's 35% plus corporate tax rates.”

Now I know the demise of the manufacturing sector in the US has been greatly exaggerated by populists like Pat Buchanan. I have argued several times in these pages that much of the drop in manufacturing jobs in the US is due to increased productivity. In other words, the US is making more with less. i.e. this is a Good Thing. But still… the mountain of regulations and the unnecessary risks and arbitrary constraints they impose on manufacturers can’t be good for America’s (and Canada’s) vitality.

The Obamariods like to present the free market GOP with a choice: you can have pro-growth economic policies (i.e. lower taxes), or you can cut the deficit, but you can’t have both. Well, here’s a way you can have your cake and eat it too: cut regulations. Every regulation you eliminate works on both problems: it promotes growth by eliminating an obstacle to entrepreneurs while simultaneously cutting costs because there is incrementally less for the bureaucrats to do.

Of course, eliminating their false choice is why the left doesn’t want to talk about deregulation. Their biggest fear is that it will work too well.

 

Our economic crisis and its solution

On the one hand, a free economy and the fractional reserve banking system underlying it are inherently unstable. It is unstable in a chaos theory kind of way. That is, while an economy's behaviour is deterministic, its forward trajectory in state space is unpredictable due to the sensitivity-of-initial-conditions problem. This means that it is almost impossible to predict the future behaviour of today’s financial crisis.

But while this is true about out economy, it is not all that is true about our economy.

What I am getting at is best described through analogy with physics. Most physical systems are chaotic in the same way. For instance, take the 'three body problem' in classical gravitation. There is no analytic solution that describes perfectly the motion of three bodies that takes into account their gravitational attraction to each other. This means that the forward trajectory of these bodies is unpredictable – and for the very same reason that our financial system cannot be predicted. But this does not mean that the system spins out of control. 

Why not? 

Because those three bodies are also governed by various conservation laws (mass, energy, momentum, angular momentum) that provide powerful constraints on what the system can do.

In the same way, there are similar constraints governing our financial system. Two of them are: 1) that in the long run, savings and investment must equal; and 2) that at any given time, the sum total of the wealth in our society is finite and equal to the amount of goods and services the economy produces. Let us look at each in turn to see how they constrain the economy in beneficial ways. 

1. Savings must equal investment. 

What does this mean? Savings are the money that you put away in the bank (or other financial vehicles) for future use. Investment is the concrete activity pursued for long-term profit. For instance, we build houses, factories, do R&D that will only pay off many years down the road, etc. These two things must equal, or there is trouble.

The best way to explain this is via another analogy. Consider an electrical grid. In a power grid, generation and load must be balanced at all times. And if they are not balanced, they will balance each other in ways that are undesirable. The same is true for investment and savings. If they are not balanced, then an unpleasant financial crisis will happen that will balance the two. This is where we are at now. This means that the only way forward is to balance savings and investment. This is why bankruptcies are healthy. They clear off bad, unproductive debt. As long as zombie companies like GM remain solvent, they will continue to burn through precious capital that could be used productively elsewhere and the economy will remain mired. 

The S & L crisis of the early 90's was resolved when failed banks were processed through the Resolution Trust Company. Through the RTC, the government temporarily took over bad banks, consolidated and wrote off the bad debt and resold the banks that were left over - banks that were healthy, strong and capable of supporting constructive economic activity. Savings and investment were equaled. The result was the roaring 90's.

This explains why Keynsian pump priming is such a bad thing. The bubble is caused by savings and investment not equaling. The bubble bursting is savings and investment equaling in an unpleasant way. Government stimulus is essentially an attempt to reinflate the bubble -i.e. recreate the inequality that caused the problem in the first place. Bad private debt is replaced, or rather compounded, by government debt and money created from nothing by the central bank. The result is more savings redirected to unproductive ends. A real world example is Japan in the 1990's. Instead of letting bad banks fail  - and letting bankruptcy courts sort out the good debt from the bad so that new and stronger financial institutions could replace them, they spent huge amounts of money on government programs in a vain attempt to reinflate the economy. The result was a lost decade and a public debt that currently equals over 190% (190!) of GDP, the highest in the developed world (only Zimbabwe is worse).

An example where the opposite was done was the depression of 1920-1921. The laissez faire policy of the Harding-Coolidge administrations and their excellent Treasury Secretary, Andrew Mellon, was to let everything fail that was going to fail. The result was a depression that was much sharper and more severe than the Great Depression, but one that was over in a year and a half. At the end of it, the bad debt was gone and the rest of the twenties roared. 

2. At any given time, the sum total of the wealth in our society is finite and equal to the amount of goods and services the economy produces. This fact operates on the economy like the conservation of energy operates on a physical system. It restricts the severity of what can happen. A corollary is that money isn't wealth. So if the financial system creates highly leveraged financial products (such as derivatives and credit default swap) whose total dollar value ends up being greater than the total GDP of the country, it doesn't mean that the country’s net worth is less than zero. The net wealth of a country will always be the sum total of the goods and services it produces. Those goods and services are real. Money is merely a form of information. When the financial system is healthy, this information is an accurate reflection of real wealth. When the system is unhealthy, as is the case when there is a credit bubble, it is not. A bubble is really only an unevenly distributed bout of inflation. And inflation is when money fails to transmit information about wealth over time. 

To understand this, it is important to remember that the primary function of banks is to allocate productive resources between direct consumption and long-term capital. (I.e. if you take $10 out of your pocket and buy a CD, you allocate productive resources to direct consumption. When you put that same $10 in the bank, that money is loaned out to the CD manufacturer to modernize his factory.) Because inflation interferes with the flow of information over time, it skews this allocation towards short-term production so that long-term investment suffers. In the long run, the economy slowly winds down as the factories wear out. Take the Weimer Republic, when people rushed to buy a loaf of bread before their money became worthless. In this environment, long-term investment is impossible. This is why inflation is bad. This is stagflation.

When financiers end up holding derivatives valued more than the economy, all that has happened is that a bunch of people think they are richer than they really are. The solution? Let them go bankrupt - as soon as possible. The longer they - and everybody else - labours under the illusion that they are rich, the more opportunity they have to misallocate precious capital. In order to minimize total damage, speed is of the essence. 

The moral of the story is that the sooner bankruptcy is allowed to work its healing magic, the sooner we can put the recession behind us and the less total damage the recession will have caused. The flip side is short-term pain, a'la 1921. 

Which is why everybody is avoiding the solution.

All you need to know about economics in one rap video

Fredrich von Hayek and John Maynard Keynes duke it out in this clever and economics literate rap video.