Economist Challenges Conventional Wisdom on Bubble Pain, Points to Central Bank's Money Flow Management

Eliezer Yudkowsky, a prominent researcher and writer, has challenged the widely held belief that the economic pain following an investment bubble's burst stems from the physical waste of resources during its inflation. Instead, Yudkowsky argues that the true suffering is a consequence of financial destruction and a subsequent reduction in the overall flow of money, a phenomenon he contends could be mitigated by astute central bank policy. His analysis suggests that the timing of economic distress, which typically occurs after a bubble pops, contradicts the notion that wasted physical resources are the primary cause of pain.

Yudkowsky dismisses the idea that the pain of a bubble popping is due to wasted investments as "physical nonsense." He posits that if the waste of labor and materials were the primary cause, economic suffering would be felt during the bubble's inflation, when resources are being misallocated. > "If the waste were what caused the pain, everyone would be sad while the bubble was inflating," Yudkowsky stated in his post, adding that once the waste ceased, the economy should logically improve. However, historical observation shows that people often feel prosperous during a bubble, only to experience hardship after it bursts.

The real mechanism, according to Yudkowsky, involves "macroeconomic financial bullshit" and concepts like "downward wage rigidity." During a bubble, increased lending and optimistic spending inject more money into the economy, animating trades and boosting production, especially if the economy was previously operating below capacity. When the bubble collapses, this money flow dramatically decreases, leading to fewer transactions, underutilized factories, and unemployment, even though the physical waste of resources has stopped.

To counteract this, Yudkowsky advocates for central banks to adopt "Nominal GDP Level Targeting" (NGDPLT). This strategy involves the central bank committing to a predictable, stable growth path for the total dollar value of spending in the economy (nominal GDP). Proponents suggest NGDPLT would automatically loosen policy during recessions and tighten during booms, providing a more stable economic environment. While some economists support NGDPLT, no major central bank has formally adopted it as its primary policy framework, a situation Yudkowsky attributes to "civilizational-inadequacy."

Yudkowsky points to Australia's experience during the 2008 Global Financial Crisis as an example of effective central bank action. Australia largely avoided recession through aggressive monetary policy, including significant interest rate cuts by the Reserve Bank of Australia, which helped maintain aggregate demand and confidence. This demonstrates, he argues, that a central bank, by wisely managing the money supply and maintaining a predictable growth track for money flow, can prevent the pain of a bursting bubble from severely impacting the broader economy.