If what you say were true, then we wouldn't be suffering from unemployment. We'd suffer from massive writedowns in our wealth (as we realize our malinvestments) but labor would be redeployed to new ventures. Effectively, we'd be working our assess off harder than before, but receiving a lower quality of life in return.

In reality, however, the economy is not at full employment. If we malinvested before (effectively did useless work), that should be a sunk cost. We wouldn't receive the future benefits we expected from that work, but that wouldn't preclude us from continuing to work. Malinvestment is not a reason for unemployment.

No, we're in a liquidity trap. Option A is monetary policy. That has been tried and exhausted. Option B is fiscal policy. Bring out the helicopters!

Labor won't be deployed to new ventures when all of the companies that were involved in the malinvestment aren't allowed to fail.

If the person I originally replied to is implying that the current bailouts create too much of a moral hazard, then that's a possibility, but that one sentence that was given doesn't do the issue justice.

Those poor investments will wipe out equity owners (and bond holders in many cases) when they are honestly documented on the balance sheet.

No rational person will make a new investment until after such honesty develops.

Suppose a consortium of Arab investors decided to believe Citi's current published balance sheet, and bought $500M of newly-issued Citi common stock at US$2.00/share, a nice discount from its $3.40/share market price. They would most likely lose every penny of that investment when Citi fesses up to the true losses.

Of course the big money investors are no longer that foolish, having been burned several times by U.S. bank "recapitalization investments" in 2007/2008. Everybody is waiting on the sidelines for honesty to develop. This flight of capital has been billed as a liquidity crisis by the Wall Street hucksters, and used to justify mammoth bailouts, but in reality it is a solvency crisis and there is an ocean of hot money itching to be spent on honest companies.

Yes, but redeployment takes time -- especially when everyone looks around and sees all their assumptions about what profits different activities will return are wrong, and need to be recalibrated. That research -- which happens tentatively, experimentally at first -- means some capital/labor sits on the sidelines while the necessary information is collected or created.

Redeploying labor immediately at the first things you can think of might keep people busy but can worsen the wealth destruction, if those activities wind up being of net zero or negative benefit. (By tying up workers on make-work, they could also slow the rediscovery and restaffing of valuable projects.)

Those who have lost their jobs don't necessarily have the right skills for the more economically productive jobs that hopefully get created. Also, they don't necessarily live in the right places.

Practically, politics means fiscal intervention arrives late, stays too long, and is targeted to reward favored groups and centralize power.

There's no separating the two without a magic wand to implement benevolent stimulus without a political process.

Uh, why not? I don't get it. Of course business liquidations and a decline in capital investments produces unemployment.

But look at the bigger picture. We have productive economic resources (labor), why should they ever be sitting idle? It's not like we don't have problems to solve. We have to pay off our debt to the Chinese. We have to figure out what to do when the oil runs out. We have to make sure we don't destroy the planet sometime during the next century. We need to figure out how to take care of all the baby boomers once they retire. There's LOTS of work we need to be doing, but we're sitting around twiddling our thumbs. That makes no sense.

The original source of our financial crisis is the collapse of subprime mortgages. People are getting kicked out of their homes, which has several effects:

- There are now a lot of houses on the market, driving prices down and reducing demand for more construction. Construction companies suffer, as do all of their labour and material suppliers (lumber companies, contract labour companies, etc)

- Banks have reacted to the defaults by attempting to protect themselves from further risk, meaning that it's harder than ever to get a mortgage. The effect is a similar drop in housing demand, with similar results as above.

- As the true scope of the problem unfolded, people began bailing on bank investments, driving prices down, and eliminating wealth that normal people have stored up in the form of mutual funds and such. This loss of wealth amongst "average people" has driven down consumer demand, and thus basically every other industry out there.

- As investors realized that consumer spending will be down, they withdraw their investments in these companies, resulting in further depression of the stock. This in turn causes more loss of wealth for people holding these investments, and causes a vicious cycle.

Nothing exists in a vacuum.

The question that I see being repeated in the media these days is "what are the banks doing with the bailout money, why aren't they lending it?" Perhaps the answer is that there is currently nobody out there who is a good enough credit risk to lend money to. Another possible answer is that the banks now realize that they've lost the ability to quantify credit risk correctly and they are going to need to relearn that skill.

PS: We are not in a depression, but a major goal should be to avoid a depression while we let this recession fix many of the problems your talking about.

The policy prescription for the current crisis is to beef up food stamps and heating assistance programs so people don't starve or freeze, and then let all nonviable businesses fail as quickly as possible so they can be reconstituted as profitable companies.

"From 1929 to 1934, U.S. personal income plunged 44%, real output nosedived 30% and the unemployment rate soared to 25% of the American labor force." and the great depression still had 5 years left.

"By Jan 1, 1934, as many as half of all residential mortgages were delinquent" let alone all the ones that had already failed.

And it can fall far further in the next one. It's a house of cards and the bottom is far further than you might expect.

We had a positive personal savings rate last month. Once you have a positive saving rate there is no long term problem with spending. (http://www.bea.gov/briefrm/saving.htm)

Now government spending is honorably out of whack, but that's not really related to what you're talking about. (http://www.frbsf.org/education/activities/drecon/answerxml.c...)

If hoarding leads to an irrationally priced money, rational people will quickly realize this and exchange their money for other alternatives that have become favorably priced.

Once this tipping point is reached, others will realize that they were overvaluing their money and the pendulum will swing back.

For what it's worth, the only economists who consistently avoid setting off my bullshit meter are the Austrians. And yet, their views border on lunatic fringe according to mainstream economists. In a world where those same economists set policy, that is an alarming combination.

The core problem is that economics cannot use falsifiable experiments, and it is very highly politicized.

I agree that falsifiable experiments are difficult in economics, which is why we must rely instead on logic and reason---a strategy seemingly abandoned by modern economists.

I remember the ridiculous (and since discredited) argument by Card & Krueger that increases in the minimum wage increased employment, at least according to their data. And yet, when you raise prices on normal goods, the quantity demanded falls; if you force companies to pay employees more, they will hire less. If the data say otherwise, the data are either wrong or too noisy to be trustworthy. (Unfortunately, their paper wasn't merely an academic curiosity---it gave Bill Clinton and Congress political cover to raise the minimum wage in 1996.)

And now we hear economists fret that Americans, who have been under-saving and over-spending for years, may yet ruin the economy---by saving too much and spending too little. Someone needs to tell them that wagging your finger and saying "liquidity trap" doesn't magically give the emperor clothes.

N.B. I predict the rise of quantum decoherence theory will change this picture in fairly short order.

But many other are losing their jobs simply because of friction caused by the increase in demand for money. All contracts ( wage contracts and debt contracts) were written assuming an easier availability of money. When a deflation occurs, many businesses go bust not because they were "malinvestment" but simply because their contracts were denominated in 2007 dollars, not 2009 dollars. The correct response is to print money to prevent the deflation, thus removing the need for every business in the country to into bankruptcy court to get out of their debts.

Before the Great Depression, many people wanted cars and they could afford cars. After the great depression, the production of cars were even greater. Why did the factories need to stay idle during the great depression? Idle automobile factories were not a result of liquidating malinvestment, they were a result of collateral damage from deflation.