More on Saving and Investment

This article is a much better exposition of some of the ideas I was trying to get at in my post titled Bad Investment.

Here's a related post by Eric Falkenstein that discusses how people and businesses behave when their performance on fundamental measures is not well correlated to their earnings.

Bad Investment

I kind of understand the reasons behind the dot-com bubble. The emergence of new, paradigm-shifting technology suggested that untold fortunes might be made by the fearless who got in on the ground floor. The real estate bubble is more mysterious.

Who really thought that housing prices were accurately reflecting a balance between the number of available units (supply) and the ability of consumers to pay (demand), circa January 2006? Or even a year earlier, for that matter. Even casual attention to the loan-making process during this time would suggest a problem with the direction of the investments that were being made. Hindsight is 20/20, but at the time I did decline to take on such a loan myself because it just all seemed so ridiculous (though I should have taken it, had I been a more rational actor). 

I'm clearly no economist, but I think that the bubbles during the last halves of the last two decades must have a common cause. In both cases enormous investment was made on a basis of careless speculation bordering on willful self-injury. Why?

Some people talk about interest rates being artificially low and blame Greenspan and Bernanke. I'm no expert on that one, but I do wonder whether interest rates were low only because of the actions of the Fed. My suspicion is that low interest rates alone didn't cause all that bad investment, but that both the low interest rates and the bad investment were caused by a third factor.

I'm not quite sure how to phrase it, but doesn't it seem like there was an awful lot of capital that needed someplace to go during both of these booms? I've heard the phrase global savings glut bandied about, but I'm not sure exactly how to evaluate that. One thing seems sure: typical due diligence prior to investing was not being practiced in 1996 or in 2006. Is it simply that there were not enough quality investment opportunities available during these periods? Too much money chasing too few opportunities? That story seems to fit the facts, but I can't quite make sense of it.

Under what circumstance is there too much money ready to be invested? It's not the kind of thing I've heard debated, but I can imagine a world where saving is happening at a higher rate than is consumption. In that world, each saved dollar 'wishes' to be put to use producing, but most production is giving slim returns because demand is weak (e.g. most needs are already satisfied, so there's not a strong incentive to buy more). That doesn't sound like the USA we know and love, and whose savings rate has been negative in very recent memory. But it might be a description of the world when evaluated on net. 

Don't look at me like I have data to support that argument, because I don't. But imagine how a world like the one I've described might behave. Because many, many people are choosing to postpone spending until a later date, there are many dollars available for investment. But they can't be profitably put to work building factories to make gadgets to sell to people, because people are saving instead of buying gadgets. So investment dollars are available cheap, chasing every opportunity to earn some kind of return. Consequently, interest rates fall (with or without Bernanke's say so). In such an environment risky investments that pay well look much more attractive than they usually do because investors are desperate. Investment schemes based on the promise of unproven new technology or the faulty hope of perennially rising home values almost make sense. Eventually this kind of bad investment gains a certain amount of respectability and even becomes an indispensable part of every portfolio, because no one wants to be left earning pennies on securities that give Treasury Bill-like returns while the stupid money (other banks, municipalities, and private investors) make relatively good returns and don't seem to be blowing up.

This story is so simple that it must be wrong. Please tell me how it's wrong.

But if we assume that it's right, what policy can fix it? Or should it be fixed?

What if the solution is for governments to tax and spend in order to forcibly lower the savings rate?

What if we believe that taxing and spending is the solution, but it turns out that taxing and spending in the US doesn't fix the problem because we don't save much anyway, and that the real savers are in China and India?

Business Cycle

Systems with feedback loops can have complicated, difficult to predict behavior. However, there are three basic varieties of simple feedback loop, and understanding these three types can lend insight into the behavior of more complicated loops.

The first type is positive reinforcing. These loops runaway in one direction forever, until something in the system changes and the dynamic is allowed to breakdown. The classic example is the runaway population growth of bacteria in a petri dish.

The second type is balancing. This kind of loop is characterized by equilibrium among opposing forces. It takes effort to push these systems away from their natural equilibrium point, and they tend to fall back again once the effort stops. However, they can be complicated by having multiple points of equilibrium.

The third type of feedback loop is oscillating. This is essentially a special version of the balancing type of feedback loop. As with the balancing type there is a force and an opposing force, but in this case the opposing force has a delayed response. As a result the system swings from one extreme to another, like a pendulum, as the system is dominated first by one force and then by the other. Aviators may refer to this behavior as PIO - Pilot Induced Oscillation. If there is a delay between when the pilot gives an input to the control surfaces and when the aircraft responds then the pilot will tend to give too much input and then over-correct, sending the plane into a potentially fatal oscillation. In a way, the PIO acronym puts too much blame on the pilot as this problem is really a result of the system dynamics.

I think the business cycle is the result of an oscillating feedback loop in the economy. Not much of an insight really, except that it implies that there is something structurally wrong with the economic system. Left to its own devices, the system will keep exhibiting this behavior.

The story I was taught in high school economics was that the Fed had been established to interrupt this oscillating behavior, by anticipating it and correcting for it. I was told that the Fed had been enormously successful in that role. I'm not sure that was true.

Can there be a market solution for bubbles and the Business Cycle?