One of the problems with Neoclassical economics is that it assumes that the economic system tends toward stability.? In all of my years of doing quantitative analyses of equity and debt markets, as well as the economy as a whole, my models have shown me that there is a tendency toward mean-reversion, but it is a very weak tendency that is swamped by shocks to the system in the short run.? The further we are away from the mean, the stronger the tendency toward mean-reversion.

But, as I have often said, the beauty of Capitalism is its ability to handle instability.? There is creative destruction as some economic concepts are no longer as useful as they once were — e.g. fixed-line telephones, newspapers, buggy-whips, everyone should own a home, residential real estate is an easy road to riches, etc.

It is dangerous to try to stabilize that instability, to create a great moderation of volatility, to keep marginal concepts from failing, whether through fiscal means (tax incentives and subsidies), or monetary policy (lower the policy rate or some banks will fail).

It’s good to see bad economic concepts fail, along with those who finance them, particularly when a society is not so dependent on debt finance that the failures will not cause a cascade of more failures.? Failures allow resources to be redeployed to more productive uses, and keeps capital focused on the best opportunities.? Unemployment stays cyclical.

But when failures are quickly bailed out through overly easy monetary policy, as well as a fiscal policy that favors debt over equity, debt grows like crazy, because there is little to restrain it.? Why should the politicians care?? Easy money means prosperity today.? Bureaucrats don’t argue with the politicians; that is suicide.

Debt issuers crave stability.? Credit spreads fall when conditions are stable, until enough marginal borrowers take on debts that they can’t afford, and the bust phase of the credit cycle kicks in.? If the central bank eases too soon, as was true for the Greenspan/Bernanke era, then the bust doesn’t get to do its job.? Marginal concepts survive.? The marginal efficiency of capital falls.? Asset prices stay inflated.

This process can continue until the central bank’s policy drives the economy into a liquidity trap, because they can’t drop rates lower than zero.? (Though I wonder, couldn’t the Fed go negative, and require the banks to pay them interest on reserve balances?? Perverse, I know, but what isn’t perverse today?)? The central bank can further lower rates, a subsidy to bad decisions, by buying long debt, and maybe credit-sensitive debt (not yet, but wait and see).

That’s where we are today.? Now there are two competing theories for why we are in this mess.

1. Aggregate demand has failed, so the government needs to step in and spend to keep growth going in the short-run.
2. Our economy is too levered.? We need to adopt policies that reduce indebtedness, and also expect that these policies will cause some pain in the intermediate-term, but that it will give us a healthier economy in the long run, that is, for our children, even if we are dead.

My view is that neoclassical economists are wrong.? Aggregate demand has failed for four reasons:

1. Overleveraged consumers will not readily buy.
2. Citizens of overleveraged governments will not readily spend, for fear of what may come later from the taxman, or from fear of future unemployment.
3. Aggregate demand is mean-reverting.? It overshot because of the buildup of debt, and is now in the process of returning to more sustainable levels.? The same is true of private debt levels, which are being reduced to levels that will allow consumers to buy more freely once again.
4. When the financial system is in trouble, people get skittish.

The thing is, we are not in a liquidity trap, as much as we are in a broken financial system.? Ordinarily, savings in a bank lead to investment.? The bank lends the savings.? When the banks are impaired, or forced to put up more capital against their operations, as financial reform properly will do, lending is light.

If we give it enough time, willingness to lend will recover, without government help.? That implies that debt levels mean-revert across the economy down to levels where people aren’t concerned about their own debt, or the debts of the government.? We are in a process now where the private economy is properly trying to reduce debt levels, and the government is interfering through monetary policy, deficits, and tax credits for borrowing, in order to support the economy of the 1990s, where we needed more houses and cars, and all who created/serviced them.

Thus I will tell you that the current set of policies is not only useless, but unproductive.? Don’t keep interest rates artificially low.? It punishes savers.? Savings are what lead to sustainable investment.? Don’t stimulate the economy via fiscal policy; it never rewards the economy of the future, only that of the past.

Here are my solutions:

• Make interest non-deductible, and dividends tax-deductible.? Phase this in over five years.? Yes, the prices of houses would fall, and many other asset prices.? Venture capital would get whacked.? But the system that would emerge by 2020 would be delevered, more profitable, and much more stable.? It would grow more rapidly as well.
• Issue coupons to taxpayers? that can be applied to repay debt.? That would delever the economy rapidly, aside from the government.? (A weakness of the idea.)
• Bar the Fed from running overaggressive policies.? Fed funds can never be more than 1.5% below the 10-year rate, or 0.5% above the 10-year rate.? Constrain the madness of unelected bureaucrats that see no problem in weakening the credit of the economy.? Also, eliminate section 13:3, so that the Fed can’t do bailouts.? Let Congress, who we elect, sign off on every bailout, so that we can kick them out thereafter.
• Worst case scenario: Inflate the currency, such that it passes into goods prices.? That will lower the value of old debts, making them not as much of a burden to the economy.? But try the other three strategies first.

I write this not because I get any kick out of austerity, but because I think the present set of solutions will not only not work in the long-run, but make things worse.? There will be no recovery without some pain.? People always want something for nothing, and that never works in the long run.? If we want to have two or three lost decades, like Japan, well, keep following the status quo.? But if we want to get this over with, follow my solutions, and stop interfering with the economy.

As it is, there are limits to borrowing for any government in real terms, and the present set of policies will test those limits.? Perhaps Greece or Japan will be the canary in the coal mine for the US, but will we learn the lesson early enough to avoid default or a severe inflation?