Steve,
You write, "By the way, it is true that banking panics were a regular feature of the American economy up through the Great Depression and New Deal reforms. But is there any evidence that harmed real economic growth? Financial losses, insolvencies, etc. are wrenching, but they are part of the feedback mechanism that ought to guide capital allocation.".
But with banking panics we're not talking about mistakes and inefficiencies made by logical, sophisticated managers with high levels of information, and then the system just purges and penalizes those mistakes. We're talking about illogical and unnecessary panics that occur largely as a result of a massive asymmetric information and externality problem and then they become a self fulfilling prophesy. They often happen even when there's little or no fundamental reason for them, due to the huge lack of information and expertise on these things by regular people, which is pretty much everyone except the tiny sliver of the population who have studied and trained in depth in these areas of the economy.
So many of the mistakes made by people regarding economics (including lots of trained economists) come from acting as though their models are exactly reality. When a model assumes, as most of the basic ones do, that everyone in the economy has perfect information about everything, perfect expertise and education about everything, and perfect rationality, this is fine, as a way of isolating some of the important factors in an economic situation, to see better how they work by looking at what they do in isolation from other factors.
But then after you have isolated all of the important factors and studied them in various models, you have to ask what happens in reality where they are all combined together. What will be the aggregate of all of the forces pushing in their different directions with different amounts of strength. How will the results be altered by the inclusion of the real phenomena that all people don't have Ph.D.s in every subject, and don't have 100% of every single sliver of information in the economy stored and constantly updated in their brains.
And now a big tangent into academia (but I think it's worth the diversion):
The above questions are obviously what a good economist should ask and really think about, but a lot of economists don't. Moreover, sadly, there's a penalty to most economists for spending much time thinking about these kind of things, because most are evaluated almost completely on publication production, and they will usually produce a lot more if they just save time and act as though the models are given, then micro-specialize in an area, and just do lots of little probes based on taking the models as givens.
For most economists it's dangerous to their career advancement to spend much time thinking about the intuition, and how the models apply to the real economy, and how relaxing the assumptions changes the results, and how things outside of their micro-specialized area relate and interact. This kind of overall intuitive thinking and analysis, reading intuition books like "Peddling Prosperity", reading outside your micro-specialization, etc., can take a lot of time away from what is for most economists their fast bread and butter – assuming the models are reality, taking them as givens, and doing some little probes or empirical tests. There's a lot of pressure not to take too much time away from that, at least for the 99% of economists not at top universities, because it's publish or perish (It's mostly publish or perish at top universities too, but there they put more than just a little weight on intuition, insight, and long term promise).
I myself spend huge time on intuition, the bigger picture, and interrelations, as well as important subjects that the largely insular gatekeepers of the top academic journals turn their noses up at, like much of behavioral and especially personal finance, and normative and practitioner corporate finance. Society would really benefit if academics would bring their advanced statistical and theoretical skills to the effort to advance these areas, but because those who pay for most academic work – politicians and voters – can understand very little of the jargon and math in the papers, they can't distinguish between research which is highly socially beneficial and research which is much less socially beneficial, so they can't bring much pressure for efficient changes like this, at least not directly. I'd like to see something like government appointed boards of academic experts with fiduciary responsibility and powers to oversee and pressure academia's chiefs to publish and reward research based on its social benefit.
So, the big asymmetric information problem in academia fosters a lot of inefficiency. It allows journal editors and department heads to get away with a great deal of insularity. As for myself, luckily, our business and investment activities have done very well, and we have enough money saved that we don't really need university income, so this obviously makes it a lot easier for me to just go off and work on what I want to work on.
Economists at the top universities, as I alluded to, do in fact have more leeway to think about intuition, and how the many aspects of the economy as a whole interrelate, rather than just focusing on a micro-specialization. And tenure certainly decreases the penalties for not cranking out a lot of publications, but there's still a lot of pressure to publish even at the top universities and among those with tenure; there's still strong pressure to crank out pubs and not spend too much time thinking about intuition and what happens in the real and broad economy where the neat assumptions don't hold.
I am being very critical of economics and finance academia, but as I said in my second May 11th post: "Academia may have serious flaws and waste, but it's essentially the only game in town for so much of the important things it does, and the good that does come out is so valuable it's immensely worth having to pay for the waste that's hard to fight in academia's insular world of massively asymmetric information.", and let me add, we also cannot say just let the free market provide this research because due to externalities, inability to patent, and many other market problems, the free market would underprovide and underdiseminate this kind of research in a grossly inefficient way.
End of tangent, now back to banking panics, recessions and depressions:
These just aren't efficient market feedbacks, like companies overinvest in high speed Internet cable, and so capacity gets too big for consumer demand and they start losing money and go out of business, sending the message to not move more money into Internet cable. And even in that case, externalities could make the market message an inefficient one, where a strong government role can increase efficiency and welfare.
With panics the market messages become extremely inefficient and detached from fundamentals. You get self fulfilling prophesies that don't just lead to purging of inefficiency, they lead to severe demand crunches that result in enormous amounts of unnecessarily idle human and material capital for long periods of time, and this certainly lowers wealth creation. Without Keynesian measures, in the long run prices would come down, and that would relieve the demand crunch, but as we saw with the great depression, the long run can be very long, and great human suffering and trillions of dollars in lost production can be the cost of waiting when you didn't have to. This is why Keynes said, "In the long run we're all dead."
Moreover, any market message regarding bad capital allocation is still there whether the central bank increases the money supply or not. If there is overbuilding of fiber optic cable, prices and profits for fiber optic cable relative to prices and profits for other activities don't change when the money supply is increased. It's not like the money supply is increased only for a favored fiber optic cable industry. Smart businessmen still won't put their new money into relatively low profit, overbuilt fiber optics. They will put it into more promising industries.
A quote from Krugman to sum it up: From "The Return of Depression Economics", page xv:
Most economists, to the extent that they think about the subject at all, regard the Great Depression of the 1930s as a gratuitous, unnecessary tragedy. If only Herbert Hoover hadn't tried to balance the budget in the face of an economic slump; if only the Federal Reserve hadn't defended the gold standard at the expense of the domestic economy; if only officials had rushed cash to threatened banks, and thus calmed the banking panic that developed in 1930-31; then the stock market crash of 1929 would have lead only to a garden-variety recession, soon forgotten. And since economists and policy makers learned their lesson – no modern treasury secretary would echo Andrew Mellon's famous advice to "liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate...purge the rottenness out of the system" – nothing like the Great Depression can ever happen again.
Then Krugman goes on to say that many have not learned these lessons, and we are not doing enough.
I also strongly recommend you read Krugman's 1998 Slate article, "The Hangover Theory". This really gets to the heart of things and teaches a lot in just a couple of pages. A quote to whet your appetite, "A few weeks ago, a journalist devoted a substantial part of a profile of yours truly to my failure to pay due attention to the "Austrian theory" of the business cycle—a theory that I regard as being about as worthy of serious study as the phlogiston theory of fire.".
One more quote, because I'd really like to motivate you and the other readers to read this article:
Yet, for all its simplicity, the insight that a slump is about an excess demand for money makes nonsense of the whole hangover theory. For if the problem is that collectively people want to hold more money than there is in circulation, why not simply increase the supply of money? You may tell me that it's not that simple, that during the previous boom businessmen made bad investments and banks made bad loans. Well, fine. Junk the bad investments and write off the bad loans. Why should this require that perfectly good productive capacity be left idle?
Finally, I'd like to give an analogy to help show the inefficiency of banking panics. At a football game if others start standing up for a better view, then it's best that you stand up too, and eventually everyone may stand up. But almost all would be better off if everyone had stayed seated. As Cornell economist Robert Frank would say, standing up is "smart for one, dumb for all", and this is the title of chapter 10 of a book of his I highly recommend, "Luxury Fever". An important quote from that book: Despite the mythology actively propagated by Republicans, Adam Smith, "although he is widely remembered for his account of why the individual pursuit of self-interest often promotes social ends, he was under no illusions that this was always the case." (page 171).
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