Economics in Crisis
Ben Bernanke told a town-hall-style meeting in Kansas this week that he was not going to “preside over the second Great Depression”. Dr. Bernanke appears to be fighting to save his job and reaching out to the people for understanding and support.
He told the audience that he had not wanted to prop up the big finance companies: indeed, “nothing made me more frustrated, more angry, than having to intervene” when corporates were “taking wild bets that had forced these companies close to bankruptcy”. Although “disgusted”, Bernanke was minded that “when an elephant falls down, all the grass gets crushed”.
This episode is interesting because it reflects a notable former economics professor confronting the possibility of a depression. It comes at a time when world trade and economic production is tracking the Great Depression. It would have appeared an impossibility even four years ago and economists are reeling, especially people like Paul Krugman are saying a macroeconomics education is “a costly waste of time”. He told an LSE audience that most macro was “spectacularly useless at best, and positively harmful at worst”.
Few Crystal balls
Economists did not see the crisis coming and are somewhat divided on how to treat it. When I studied economics at the LSE, it was widely assumed that crises were a thing of the past. Economic growth could be managed, and any small fluctuation in demand could be easily dealt with by adjustments in monetary and/or fiscal policy. We students thought it was not difficult to plan for growth. Paul Samuelson’s “economics”, our textbook dismissed crashes in a few lines.
But there was a stable environment. Banks were conservative institutions and very reluctant to extend credit. I recall an interview when I was a student, on a good scholarship, where I asked for a loan in order to buy a cheap Vespa scooter( these were much admired in the UK). I was given to understand that the risk was unacceptable. The manager implied that the mighty Midland Bank could come crashing down if I failed to meet my repayments, which I might do if I had an accident. I was in my mid-thirties when all that changed, and credit cards were showered upon me.
The main source of economic instability in my earlier life was foreign exchange. But there were strong management systems. In the UK and NZ foreign transactions were controlled. Tourists had limits on the amount they could spend. A property bubble was inconceivable as mortgages were tightly controlled. Practices were solid, and the theory appeared robust.
Classical economists assumed that full employment was usual because supply created its own demand. They thought that income was either spent or saved. Spending stimulated the economy and savings went into investment
The theory did not explain the Great Depression. Keynes explained that uncertainty motivated entrepreneurs and savers alike to stay their hand. Both might develop a liquidity preference. Demand would fall. If private sector activity slowed, the public sector should be involved through low interest rates and public works if necessary.
The theory was avidly adapted in the western world. Keynsian economics worked to get the world out of depression, manage the war effort in the UK and USA without massive inflation, and promote growth though to the 1980’s. But economists were baffled by stag-inflation, and in the US split into two camps.
Freshwater v. Saltwater Schools
The University of Chicago blamed stagflation on central bankers who meddled too much in the economy in order to smooth oscillations. The lake-siders believed in the classical assumption that markets cleared, eventually goods were cleared leaving no inventory or unemployed workers. Their opponents were the coastal universities ( “salt-water school”) who held true to theory that markets could malfunction, justifying state intervention.
The Economist has recently reviewed this debate and said eventually the schools melded into brackish macroeconomics. One product was “inflation targeting’, embraced first by New Zealand, and later by Canada, the UK, Sweden and some emerging countries. Ben Bernanke was a renowned member of brackish economics. From the mid-1980’s until recently it seemed that macroeconomists knew what they were doing. Certainly there was price-stability and that was also the focus of central banks.
Economists and Central Bankers failed to appreciate the risk of financial instability. LSE professor William Buiter now argues that training in macro is a severe handicap. Student worried about the cost of goods and wage rates but did not think of the price of assets. Too much faith had been put in financial markets, and the financial system was under-studied.
In many macroeconomic models, it is assumed that insolvencies cannot occur. It stretches the bounds to credulity to discover that the Bank of England’s model is indifferent to whether business is funded by equity or credit. It does not even incorporate financial intermediaries such as banks. As Buiter observes, the model is useless for issues where financial intermediation is of importance. Pity this crisis is such an issue!
The modelers eventually smooth away many issues because they are too complicated. They find it easier to assume a firm can always borrow as much as it needs at the going rate or sell as much as it desires. This spilled over into financial organizations who made the fatal mistake that they could always sell structured products . but as readers of this column will know, that first casualty of the crisis was “over-the-counter” markets used for selling bundles of sub-prime or similar constructs. There was no exchange for these goods and sellers could not establish a market. Many firms disappeared in a liquidity spiral. It brought back Keynes’s concept of liquidity preference.
The Fed also had models which have not stood up well. In the summer of 2007 it predicted that even if the housing market turned down by 20%, GDP would fall only by 0.25% and there would be negligible unemployment. All the Fed had to do was reduce interest rates by 1%, and the damage would be contained! Fantasy in the Fed!
ECONOMICS IN CRISIS 2
On a visit to the London School of Economics in November 2008, H.M. The Queen demanded to know why nobody had anticipated the credit crunch. Predictably the School set up a committee, even co-opting the Bank of England and arch conspirator Goldman Sachs. With lightning speed it replied last week, a mere eight months later.
It blamed “financial wizards” who believed that their plans to protect the financial system were infallible. They were guilty of “.wishful thinking combined with hubris”. This is more charitable than the view put forward in this column recently (NBR 24 July) that the wizards are corrupt. The letter says, moreover, that the crisis was “caused principally by a failure in the collective imagination of many bright people…to understand the risks to the system as a whole”.
As explained last week, this is also the view of Ben Bernanke who is “disgusted” because corporates took “wild bets that forced these companies close to bankruptcy” ( NBR July 21). Nevertheless, at the same time I pointed out that the models used by the Bank of England were absurd in concentrating on price and labour cost movements but having no interest in credit.
Lack of imagination in economics
That brings the discourse focus back to economics, and more discussion of why economists in general have been found wanting. The Economist summed up the charge.. “they helped cause the crisis, that they failed to spot it, and they have no idea how to fix it.”. The charge is comprehensive, and untrue and unfair to all economics and economists, but it appears to have a hard core of substance in the case of macro and financial economics.
The critics have emphasized the flawed assumptions in models. Models assumed market efficiency: a firm could always get credit at the going rate and sell at the going rate. In the crunch the market for derivatives disappeared and many desperate firms could not get credit. Indeed, banks remain reluctant lenders, even to each other, and credit is tight in the US, UK and EU.
I explained last week that the Bank of England model did not include banks, and the Fed assumed away asset bubbles. Both banks focused on price not credit. The Fed also assumed asset booms would be smoothed by efficient markets, but even if they did not, it was more efficient to let them run their course and clean up afterwards. “Efficient markets” doctrine clashed with stopping a bubble forming.
Macroeconomists had imperceptible interests in financial markets. These enjoyed perfect information, competition, and always cleared. Their models assumed an asset would hold its price, even if everyone else was selling. They also though a few years data was enough: it established that house prices never fell and stock markets never lost more than 5%.
They had no interest in fiscal policy because it had few effects, it could be left to others such as political scientists. Paul Krugman says that of the 7000 papers published by the US National Bureau of Economic Research (1985-2000) only five mentioned fiscal policy in the abstract or title. The Bureau is the central clearing-house for macroeconomic research; it also dates recessions.
Nastiness in common rooms
Many economists are uninterested in the real economy, but they are capable of being perturbed when Paul Krugman dismisses their discipline as spectacularly useless and positively harmful. This could affect student numbers and cannot be ignored! Krugman compounds his insults by saying the masters should be re-read, especially Keynes in order to get back to a sound basis. Macro, he says is in a Dark Age having lost the wisdom of the ancients.
Krugman’s Keynesian call for massive spending is not universally supported in common rooms. One issue is the size of the multiplier. Keynesian’s often argue that a dollar spent by government on public works (now called “infrastructure”) resulted in more than a dollar’s worth of stimulus. Economic critics like Professors Lucas and Barro criticize the estimates of Barrack Obama’s economic advisors as absurd, according to the Economist.
Financial economics is also struggling to restore its reputation. One core doctrine is the efficient market hypothesis (EMH): that the price of a financial asset reflects all available information. It is assumed that if the price was too high, smart investors would make money by shorting it. If it was too low, investors would go long. This was the basis of much hedge fund arbitrage. It was the basis too of many derivatives. The meltdown by Long-Term Capital Management in 1998 made no discernible impact on derivative writers who continued to under-value systemic risk.
Behavioral economists have been critical of financial economics for a long time. They insist that prices can get out of line for a long time, and emphasize that investors get too exuberant in booms and too much given to despair in slumps. But although the EMH is dented, it has yet to be replaced.
I personally feel that the lack of imagination admitted by LSE’s wise men owes a lot to the neglect of history, both of economic history and the history of economic ideas. Like Krugman, I have been re-reading classic writers and have found that crises have attracted much study in the past. I have read some great thinkers on a record of events, like Bagehot on the 1885 crisis and Lionel Robbins and J.K.Galbraith on the Great Depression.
There have been so many crises in the past that boom and slump is obviously inherent in capitalism. I have half-written a book making boom and slump the central part of a new interpretation of NZ history but lack the funds to complete it. I have no doubt there is a need for such history. (Gillian Tett’s “Fools Gold” helps explain the recent crisis)
While history can result in convincing explanation, there is also a need for a theory of crises and explanations of their everlasting occurrence. At another time, I hope to show that ideas from Sismondi (died 1842) Aftalion, Speithoff, Cassel and Schumpeter have relevant insights.
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