Open Thread: The New Normal

NPR

The old normal meets the new one.

Jeff writes:

For a while now, the same question has occurred to me whenever experts debate our current economic troubles. Whether it is Geithner discussing liquidity problems suppressing prices or debates about mark-to-market, the fundamental argument seems to be what the new normal is.

From one point of view, the Old Normal was artificial, fueled by the giant pool of money, cheap credit that inflated prices and led to rampant and wasteful speculation. Poor investment choices, excess housing now falling into disrepair, defaulting mortgages, all make that pool of money less gigantic. The real liquidity crisis was the over-liquidity before the housing bust, and current liquidity levels are the New Normal, reflecting the smaller pool of money and a clearer sense of the risks in real estate investment.

Attempts to restore the market to the Old Normal are essentially trying to reinflate the bubble, just as Greenspan did. Bank losses are real, banks have a solvency problem, the money is gone, and the only question is who pays to recapitalize the banking system.

From the other point of view, the current problems we are having go well beyond correction of a bubble. While some reduction in the size of (or rate of growth in) the pool of money is real, and rates of return on (and hence investment in and prices of) real estate may settle at a lower level for the near future, liquidity levels are far lower than these factors alone would explain. The New Normal may not be the old one, but it is much better than where we are now (or where we are headed). Specifically, current prices and liquidity levels reflect temporary psychological factors, opaqueness in complex asset values, a "bank run" mentality that harms the public good as each tries to protect himself. Government efforts to pour in liquidity and stand behind banks is an attempt not to reinflate the bubble back to the Old Normal, but rather to fight an emotional vicious cycle that would temporarily push the economy to a level well below the New Normal actually supported by the fundamentals.

I hear these two arguments over and over, and I wonder, isn't there some way to test this? If the pessimists and optimists disagree about what the New Normal will (necessarily?) be, can we look at the fundamentals? Presumably we can still measure the size of the pool of money to be invested. We can count the number of houses. We can estimate the number of houses falling into disrepair, and the growth in the population, to estimate when and at what rate new housing construction will be needed. We can assume a length to the recession, and assume that people won't want to invest in treasuries at 0.25% once the economy recovers. We can make realistic estimates about the investment returns on mortgages at that time, assuming tighter standards. We can throw in some variance analysis to allow for error in our guesses.

If the New Normal is a healthy one, it may make sense to throw ourselves and our (borrowed) resources to support the economy until it "takes". If the New Normal is a poorer one, it may make more sense to get out of the way, and prepare for it.