March 26, 2018

An article by Steven Gjerstad and Vernon L. Smith entitled “From Bubble to Depression?: Why the Housing Crash Ruined the Financial System but the Dot-com Crash Did Not,” appeared in The Wall Street Journal, of April 6, 2009.  The article cited key statistics which constituted the recent Great Recession. Even now some nine years later the article is worth rereading as substantiation of Functional Macroeconomic Dynamics. Also, that article is buttressed by a paper dated January 27, 2009 by Gjerstad entitled Housing Market Price Tier Movements in an Expansion and Collapse.

Gjerstand and Smith’s careful analysis of a) the statistics of mortgage-backed housing loans prior to the 1929 Crash and subsequent recession of the 1930’s, b) the downturn in the equities market between December, 1999 and September, 2002, and c) the Great Recession beginning in 2006 leads them to conclude that the major causes of all three crises were eroded lending standards and excessive credit, especially credit pre-1929 and pre-2006 for low price-tier housing.

Functional Macroeconomic Dynamics (FMD) identifies the condition of dynamic equilibrium as the adjustment of savings and investment to the changing requirements of the succession of phases of the creative-destructive process. It carefully explains how this adjustment is related to migrations among income strata.[1] In their analyses of propensities and abilities to save and spend, Gjerstad, Smith, and Lonergan are careful to distinguish among income strata. Case Shiller uses house-price strata. In contrast, the Fed’s gross ratios of amounts of debt service for mortgages and for consumer credit to disposable income are useless.

FMD emphasizes that the purpose of savings is sound investment and the purpose of increased credit is to support increased sound expansionary investment – sound because it does not deviate beyond the constraints imposed by technical relations. Lonergan refers to this adjustment as the “balance of the crossovers” between the basic and surplus circuits. FMD prescribes that credit for justified expansion should enter the operative circuits from the banking system through (S’-s’O’) and (S”-s”O”).[2] Thus the new money – granted on sound credit standards related to technical boundaries – facilitates an expansion of justified production rather than an inflation of prices caused by irresponsible loans through (D’-s’I’) and (D”-s”I”) swelling the monetary demand for existing products. New money is for sound expansion; and expansion of technically-justified transactions is the primary justification for new money.

The banking system is responsible for making financially justified loans. Expansion should not be excessive. Credit standards should not be destroyed so as to make defaults inevitable. It should not outstrip the ability of participants to pay for it. Expansion is limited by the possibilities afforded by the economy’s “conditions of physical geography and the cultural, political, and technical development of the population.” A normative theoretical framework is required.

A systematic explanation, then, requires a normative theoretical framework. The basic terms and relations of such a framework would specify the distinctions and correlations that articulate the causes, which are not necessarily visible, of events that are apparent to all. The framework would thus stand to the ordinary apprehension of the booms and slumps of the trade cycle in much the same way that the explanatory grasp of acceleration as the second derivative of a continuous function of distance and time stands to the ordinary, commonsense grasp of what it is to be going faster. CWL 15, lv

The infusion of money into residential real estate pre-1929 and pre-2008 was largely in the form of consumer loans through (D’-s’I’). As Gjerstad and Lewis substantiate, a vicious cycle ensued. Irresponsible loans caused higher housing prices; higher prices seemed to justify previous loans and stimulate even more bad loans; housing prices rose even higher. Finally the collapse. The math has a Ponzi form.

Gjerstad and Lewis cite statistics of excess, but they lack a normative theoretical framework. They seem to be on the brink of grasping Lonergan’s scientific formulation of Functional Macroeconomic Dynamics. They seem to intuit the theory without yet having reached the systematically and scientifically significant basic terms required to formulate a generally valid and universal set of explanatory equations. It would be great if they could supplement their statistical approach with the scientific heuristic of CWL 15. We’re sure they are quick learners and could contribute to Functional Macroeconomic Dynamics.

Now as the statistical approach differs from the descriptive, the analytic differs from both. Out of endless classificatory possibilities it selects not the one sanctioned by ordinary speech nor again the one sanctioned by facility of measurement but the one that most rapidly yields terms which can be defined by the functional interrelations in which they stand. [CWL 21, 112]

See on this website under Key Notions: Functions ; Science and Explanation ; Postulating vs Explaining .

Also see on this website Lonergan’s Goal .

[1] CWL 15, 133-35

[2] CWL 15, 55

[2] CWL 15, 55