The Great Recalculation, Camels, and Straws

Arnold Kling has been breaking new ground in economics with his Great Recalculation theory. This seems to me like an enhancement to the Austrian malinvestment model. In the Austrian model, the economy goes haywire because of malinvestment, and malinvestment is attributed to bad monetary policy, i.e. central banks setting interest rates which differ from what a market driven interest rate would be. Kling goes beyond that. In Kling’s model, whatever the cause of malinvestment, the correction involves an enormous amount of recalculation. Literally, people aren’t sure what to do and they need time to figure it out. It’s the success of the learning process that determines how long recovery will take. This is significant because it says changing monetary policy won’t make much difference in how long the recalculation takes. The Austrians should chime in by saying the recalculation will be delayed if monetary policy causes further malinvestment.

I’m seeing this all in a larger sense. While malinvestment can occur because of bad monetary policy (as the Austrians claim), it seems to me that it could occur for other reasons as well. The chief suspect is bad fiscal policy. In our case, we’ve had some really bad fiscal policy decisions in housing. We’ve also had bad monetary policy (keeping interest rates too low) and the combination was a double whammy. We can expect the Great Recalculation to take longer than normal. To make matters worse, the current government seems to making even more fiscal and monetary errors. My fear is that this will result in a triple whammy from which recovery will be exceeding difficult and drawn out.

My Congressional representative is outraged by the suggestion that some of the policies to improve housing for the poor may have caused the financial crisis. He’s right in that it was not the sole cause, but he’s wrong in that it certainly contributed. A robust economy can withstand some fiscal error, but it all got to be too much. Who cares which straw broke the camel’s back? It’s not the individual straws, it’s the aggregate.

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