7 Economic Fallacies

Below are seven fallacies to avoid in assessing the market and the economy:

1. Debt got the economy and the market into trouble. Debt cannot redeem it.

Excessive leveraging, motivated by greed, deceit and irresponsible behavior did get the economy and the market into trouble. More leveraging, more greed, more irresponsible behavior of course would not revive the economy nor the markets.

But restructuring the total debt of the economy is a totally different matter. TARP does not add more debt to the economy, even though it does add more debt to the federal government. The increase in government indebtedness is a good move if it alleviates the credit crunch and permits responsible lending and borrowing. The increase in federal government indebtedness helps reduce private sector indebtedness as well as state government indebtedness.

2. Businesses and individuals who would have failed or gone bankrupt without government help should be allowed to fall into bankruptcy, otherwise moral hazard will be created.

This is partly correct. However, in the real world not all financial trouble is caused by mismanagement or even misjudgment. When a big financial institution collapses, the collapse can bring otherwise sound businesses down with it. This would bring about job losses and credit default from individuals.

I have argued that the “bailout” of many financial institutions during this crisis did not amount to much of a bailout for the shareholders of those financial institutions, since the equity value for shareholders has been reduced by the losses and diluted by government injection of money. The government has tried to limit the bonuses to the management when these institutions were not turning in a profit and this is a way of dealing with the moral hazard problem although some critics say that the current management who are thus penalized may not be the culprits who have made the crucial decisions that produced the huge losses.

3. Predictions of a recovery are based on selected information or cherry picking.

Predictions of a recovery have to be based on leading indicators like ISM index, factory orders, and inventory changes, not lagging indicators like unemployment. With the ISM virtually improving across the globe, inventories falling and falling, and factory orders rising, the signs for a recovery are quite clear. Consumer confidence is volatile and is usually not a reliable indicator, though its trend is still useful. The signs are that retail sales are very slowly picking up.

4. Increase in the savings rate means no recovery

Americans are saving more, and that by itself is slowing the global recovery. But this is part of the necessary steps to reduce the global imbalance. Americans had been spending more than they earn and this has to change. The US needs to export more, and this is already occurring. The trade deficit in May was reduced to the lowest level in almost 10 years, $26 billion, helped by rising exports.

5. A weakened US dollar is bad for America.

The US dollar has been stronger than economic fundamentals warrant, and that is in part related to its use as the predominant means for international settlement. The US Treasuries market is also the world’s most liquid bond market. So whenever there are bad economic news the US dollar tends to strengthen.

But this is perverse and will hurt the economy. A weaker dollar will help American exports and create jobs for Americans, though Americans need to pay more for the goods they import. Americans need to work harder for less (consumption).

6. There will be hyperinflation.

The hype about hyperinflation has been floating around for quite some time. But inflation is always due to too much money chasing too few goods. There are no signs for excessive spending any time soon, and we have huge excess capacity to meet any rising demand. Corporate America is not spending too much. Consumers are not spending too much.

While the Federal government has spent huge sums of money investing in firms that otherwise would have failed, government spending on goods and services is not really excessive. It will take considerable time for the balance sheets of corporate America and for households to heal.

So there will not be much inflation in the foreseeable future because there will not be excessive spending, despite the increase in base money.

7. US dollar out of favor as reserve currency spells trouble for America.

If the US dollar indeed fades out as the world’s predominant reserve currency we can expect higher US interest rates and a weaker US dollar. That means more exports and less domestic consumption. America can still be fully employed, but life will not be as rosy as before. Spendthrift days will be gone forever, but that may be the right recipe Americans need.

Comments

[Ryu Mei Co:]

I agreed with some of your points, but others I disagreed.

For instance, "4. Increase in the savings rate means no recovery" is not entirely true. The market will adapt to a change in consumer spending behavior and thus may eventually lead to a market recovery no matter how long it takes.

Another one "5. A weakened US dollar is bad for America." is also not true. You said, "A weaker dollar will help American exports and create jobs for Americans, though Americans need to pay more for the goods they import. Americans need to work harder for less (consumption)", In this case Americans need to work hard and consume less import goods to reduce debts! Ironically this mean more Protectionism. Anybody noticing Toyota falling to 3rd place in auto sales. Americans will be buying more Ford and GM cars in the future, I bet my life on it. LOL......

Jul 16 05:59 AM

[Lok Sang Ho:]

You do not disagree with me. I cited these as fallacies and therefore they are not true, even though I keep reading people making the points.


On Jul 16 05:59 AM Ryu Mei Co wrote:

> I agreed with some of your points, but others I disagreed.
>
> For instance, "4. Increase in the savings rate means no recovery"
> is not entirely true. The market will adapt to a change in consumer
> spending behavior and thus may eventually lead to a market recovery
> no matter how long it takes.
>
> Another one "5. A weakened US dollar is bad for America." is also
> not true. You said, "A weaker dollar will help American exports and
> create jobs for Americans, though Americans need to pay more for
> the goods they import. Americans need to work harder for less (consumption)",
> In this case Americans need to work hard and consume less import
> goods to reduce debts! Ironically this mean more Protectionism. Anybody
> noticing Toyota falling to 3rd place in auto sales. Americans will
> be buying more Ford and GM cars in the future, I bet my life on it.
> LOL......

Jul 16 08:06 AM

[Dave Dorgan:]

A very thoughtful piece. I have just a couple of thoughts:
1) "The government has tried to limit the bonuses to the management when these institutions were not turning in a profit.." After the fact, this was true. However, there has been no taking into account the huge bonuses that will be paid in the future, because certain institutions took bail out (TARP) money and made grand profits in the FICC catagory. And, then paid the bail out money back.
2) "A weakened US dollar is bad for America." I agree completely. This may, however, the easy/only way for the government to get themselves out of this hole they have put us in.

Jul 16 10:00 AM

[Brandon211:]

My favorite is, "So there will not be much inflation in the foreseeable future because there will not be excessive spending." From 1979 - 1981 the U.S. saw inflation rates of 11%, 14%, and 10% per annum. This was in the midst of a major recession, when spending by businesses and consumers was actually DECREASING. The problem is that the author seems to think that spending actual paper currency is the only thing that leads to inflation, while the truth is, the easy availability of CREDIT is a much more important part of the equation.We don't produce assets in this country, we monetize assets. The government doesn't live within its means, it monetizes a massive debt. No, you cannot spend a treasury note, so does that mean it will never contribute to inflation?? Look, inflation isn't just a danger, it's the only possible outcome of this mess, whether or not we have "excessive spending" now or not.

Jul 16 10:51 AM

[Carlos Lam:]

Thoughtful analysis, though I disagree with most of it:

1. "The increase in government indebtedness is a good move if it alleviates the credit crunch and permits responsible lending."

The problem with this argument is that government debt must eventually either (a) be paid off through taxes, (b) be paid off via the printing press, or (c) be defaulted on. In the United States, we not only have A LOT of government debt, we have the unfunded liabilities of Medicare and Social Security, whose trustees concluded that the programs' unfunded liabilities total about $100 TRILLION (7 times our entire GDP!). At some point, such debt levels will be deemed unsustainable by foreign banks who lend the federal government money. They will be afraid, rightfully, that the federal government will opt to provide Medicare and Social Security instead of paying them back in dollars that have a steady value.

2. " When a big financial institution collapses, the collapse can bring otherwise sound businesses down with it. This would bring about job losses and credit default from individuals."

Should the losses that inure to those "sound businesses" and individuals be socialized to the rest of us by government diktat? If so, why? I categorically disagree that foisting losses on the taxpayer by government is a healthy policy, as it fundamentally forces hard-working, hard-saving individuals to "bail out" those who by their own choices became a part of a house of cards.

5. "A weaker dollar will help American exports and create jobs for Americans, though Americans need to pay more for the goods they import. Americans need to work harder for less"

A weaker dollar will mean that each individual dollar will purchase less oil or food. This will hurt middle-class Americans, as the purchasing power of their savings and earnings will be gutted. You are correct that Americans will work harder for less and that our standard of living will decline.

6. "So there will not be much inflation in the foreseeable future because there will not be excessive spending, despite the increase in base money."

Obviously, you're not a follower of the Austrian School. An increase in base money IS inflation. Each individual dollar is now worth less than it was one year ago. Not all prices will reflect this all at once; it will take time.

Jul 16 03:26 PM

[daves1001:]

Agree with points made by Carlos Lam.

Also -- "In the real world not all financial trouble is caused by mismanagement or even misjudgment". This statement does not seem to apply to the troubles of 2008-09. If you make many very risky bets with other people's money and lose the money, is that misjudgment or just bad luck?

Jul 16 04:43 PM

[Gregman2:]

Isn't the real question you're raising about how much government intervention to, of necessity, allow? Overall, I agree with your points.

Jul 16 07:34 PM

[mlonz:]

You said, "government spending on goods and services is not really excessive."

Going to have to call you on that one.

Jul 16 09:26 PM

[TCK:]

The problem is that the government is intentionally try to create inflation. It will be good for them as they can pay back current debt with more plentiful future dollars.

Unfortunately this will be bad for most Americans, especially the millions currently retired.

Personally, I am looking forward to have more senior citizens working at McDonald's. At least they can make change for a dollar.

Jul 16 10:00 PM

[Lok Sang Ho:]

1979 was the date of the second major oil crisis. At the time, US GDP was even more dependent on oil than today because today we have almost 90% in services. The supply shock caused inflation was wrongly dealt with by Paul Volcker using a severe monetary policy(20% plus interest rates) that plunged the American economy into the deepest recession since WWII.


On Jul 16 10:51 AM Brandon211 wrote:

> My favorite is, "So there will not be much inflation in the foreseeable
> future because there will not be excessive spending." From 1979 -
> 1981 the U.S. saw inflation rates of 11%, 14%, and 10% per annum.
> This was in the midst of a major recession, when spending by businesses
> and consumers was actually DECREASING. The problem is that the author
> seems to think that spending actual paper currency is the only thing
> that leads to inflation, while the truth is, the easy availability
> of CREDIT is a much more important part of the equation.We don't
> produce assets in this country, we monetize assets. The government
> doesn't live within its means, it monetizes a massive debt. No, you
> cannot spend a treasury note, so does that mean it will never contribute
> to inflation?? Look, inflation isn't just a danger, it's the only
> possible outcome of this mess, whether or not we have "excessive
> spending" now or not.

Jul 17 12:32 AM

[Lok Sang Ho:]

By excess I was only referring to bringing about excessive demand. I have always argued that excessive government spending has to be judged by considering the marginal benefit of that spending versus its cost. To the extent that the economy is very much underemployed, the real cost of government spending may be relatively small(cost in terms of alternative goods and services forgone). More government spending to replenish worn-out highways and bridges and other infrastructure to me makes sense.


On Jul 16 09:26 PM mlonz wrote:

> You said, "government spending on goods and services is not really
> excessive."
>
> Going to have to call you on that one.

Jul 17 12:38 AM

[Hot Richard:]

Mises would give you an F.

In Bizzaro America (where most everything is backward), the USA would not bailout failed companies, not outspend the planet 100-1 in military, and cut both spending and taxes while embracing free trade and cutting statist corporations off at the knees.

We'd also increase savings, have a strong dollar, think deflation is good, and not allow the politicians to get us into debt to get them re-elected.

Jul 17 01:42 AM

[Jeremy Dreman:]

Thank you for the article - it was good

Jul 22 02:48 PM

[Living4Divi...:]

Professor Ho -

A superb article. I agree with your central points. I agree there will be no hyperinflation. As for your sub-prediction of mild inflation. I disagree. Do you not feel there could be high inflation?

Jul 22 07:11 PM