Our Economic Crisis: The Grand Experiment

Includes: DIA, QQQ, SPY, XLF
by: John Lounsbury

I have referred to the actions taken and contemplated by U.S. government and Federal Reserve as “A Grand Experiment”. A number of discussions have caused me to think an essay on this subject would be helpful.

The economic crisis we are now enduring has a history. It started in 2007 with the recognition that sub-prime mortgage lending had been over done. We were told by the Treasury Secretary and others that this was a problem localized to certain mortgages. The rest of the financial system and the economy would not be affected, that it was an isolated and contained problem. We were told wrong.

By the beginning of 2008 it became obvious that falling housing prices were not just associated with the sub-prime mortgage market, but impacting a wide variety of mortgages. We were told that the problem was still contained to one aspect of the financial system. We were told wrong.

In March 2008 (March 12, to be exact), the CEO of Bear Stearns said, in a public statement, that there was no threat to the liquidity of his firm. Within a week, with government backing, Bear Stearns was taken over by JP Morgan to avoid bankruptcy. We were told wrong.

In September we were told that another isolated problem had arisen that required the Fed to supply $85 billion to AIG in return for approximately 80% ownership. This was represented to be the solution to this problem. So far since, at least $40 billion more has been provided to AIG. We were told wrong.

By October of 2008, we were told that a crisis was developing that had caused credit to dry up and that the solution was to create an emergency appropriation of $700 billion to buy up some debt instruments that were too illiquid in the private market to support issuance of further credit. Everything could be stabilized if this was done. Several leaders made statements to the effect that “the fundamentals of the economy were strong.” We were told wrong.

By the beginning of November, the Treasury announced that, instead of buying up illiquid debt instruments, as originally proposed, equity was being provided directly to banks to shore up their reserves. By the end of November, the Treasury announced that they were going to stop putting equity in banks because “conditions had changed”. All this implied some analysis was involved. We were told wrong.

So here we are in December. What will we be told next? I, for one, am afraid to speculate. Information that is generally available indicates that there is no plan, only a wide variety of proposed actions. I have gone through the history of the crisis to point out that our economic policy appears to be invented on the fly, in an ad hoc manner.

If what we have is a series of ad hoc actions, how should the process be characterized? I have referred to the TARP, other bail outs and proposed stimulus as a Grand Experiment. This is not a precisely accurate characterization. An experiment implies activity with a certain structure (called the Scientific Method):

  1. Define a hypothesis.
  2. Design an experiment.
  3. Collect experimental data.
  4. Analyze and summarize the data.
  5. Support or disprove the hypothesis.
  6. Use one or a collection of proven hypotheses to develop a theory.

If a theory is not refuted by all available information, it may, by passing the test of time, become a scientific law. Such laws are usually defined by equations for which no exceptions have ever been observed or imagined. Newton’s Laws of Motion are an example. Einstein’s Theory of Relativity, also defined by equations (the most famous is E = mc^2) is not a law because there are some hypothetical contradictions that have not yet been resolved.

Economics is often referred to as a science (it has been called the “dismal science”), but the variables of economics include individual and group human behavior. There are no laws in economics because the number of variables can be as large as the human population. This is where economics and physical science separate. Whereas the knowledge of the physical world is defined within the concepts of scientific laws, economics is analyzed with models and probabilities.

During the Great Depression, Franklin Roosevelt said (my paraphrasing) that we must try some things to see what works, stop what doesn’t work and try something else. We appear to be in the same boat, 75 years later.

So if this is the Grand Experiment, it is not an experiment in the scientific sense, but in the FDR sense. If we are lucky (and maybe smart), after we have tried some things and find some that work, we will be able to define a hypothesis (or several) that will benefit us in the future. If there is anything like a hypothesis right now it is a fuzzy concept that we don’t want 2009 and 2010 to repeat 1931 and 1932 so we will not try anything that looks like policy from those years. This concept is a negative idea - not to do something. As a general rule, though, in science a hypothesis is a positive statement. Proof of the negative is usually not a scientific objective, because it is difficult to eliminate the entire universe. Negatives in science disprove positive statements; they don’t prove negative statements.

So, the Grand Experiment is to collect some data and see if we were clever enough in picking a set of experimental actions to get results that will allow us to propose a hypothesis. Some experiment! No wonder they call economics the dismal science.