Thursday, October 01, 2009
Thursday, September 24, 2009
Tuesday, September 15, 2009
The Last Temptation of Risk
by Barry Eichengreen
04.30.2009
From the May/June 2009 issue of The National Interest.
THE GREAT Credit Crisis has cast into doubt much of what we thought we knew about economics. We thought that monetary policy had tamed the business cycle. We thought that because changes in central-bank policies had delivered low and stable inflation, the volatility of the pre-1985 years had been consigned to the dustbin of history; they had given way to the quaintly dubbed “Great Moderation.” We thought that financial institutions and markets had come to be self-regulating—that investors could be left largely if not wholly to their own devices. Above all we thought that we had learned how to prevent the kind of financial calamity that struck the world in 1929.
We now know that much of what we thought was true was not. The Great Moderation was an illusion. Monetary policies focusing on low inflation to the exclusion of other considerations (not least excesses in financial markets) can allow dangerous vulnerabilities to build up. Relying on institutional investors to self-regulate is the economic equivalent of letting children decide their own diets. As a result we are now in for an economic and financial downturn that will rival the Great Depression before it is over.
The question is how we could have been so misguided. One interpretation, understandably popular given our current plight, is that the basic economic theory informing the actions of central bankers and regulators was fatally flawed. The only course left is to throw it out and start over. But another view, considerably closer to the truth, is that the problem lay not so much with the poverty of the underlying theory as with selective reading of it—a selective reading shaped by the social milieu. That social milieu encouraged financial decision makers to cherry-pick the theories that supported excessive risk taking. It discouraged whistle-blowing, not just by risk-management officers in large financial institutions, but also by the economists whose scholarship provided intellectual justification for the financial institutions’ decisions. The consequence was that scholarship that warned of potential disaster was ignored. And the result was global economic calamity on a scale not seen for four generations.
SO WHERE were the intellectual agenda setters when the crisis was building? Why did they fail to see this train wreck coming? More than that, why did they consort actively with the financial sector in setting the stage for the collapse?
For economists in business schools the answer is straightforward. Business schools see themselves as suppliers of inputs to business. Just as General Motors provides its suppliers with specifications for the cold-rolled sheet it needs for fabricating auto bodies, J. P. Morgan makes clear the kind of financial engineers it requires, and business schools deem to provide. In the wake of the 1987 stock-market crash, Morgan’s chairman, Dennis Weatherstone, started calling for a daily “4:15 Report” summarizing how much his firm would lose if tomorrow turned out to be a bad day. His counterparts at other firms then adopted the practice. Soon after, business schools jumped to supply graduates to write those reports. Value at Risk, as that number and the process for calculating it came to be known, quickly gained a place in the business-school curriculum.
The desire for up-to-date information on the risks of doing business was admirable. Less admirable was the belief that those risks could be reduced to a single number which could then be estimated on the basis of a set of mathematical equations fitted to a few data points. Much as former–GM CEO Alfred Sloan once sought to transform automobile production from a craft to an engineering problem, Weatherstone and his colleagues encouraged the belief that risk and return could be reduced to a set of equations specified by an MBA and solved by a machine.
Getting the machine to spit out a headline number for Value at Risk was straightforward. But deciding what to put into the model was another matter. The art of gauging Value at Risk required imagining the severity of the shocks to which the portfolio might be subjected. It required knowing what new variables to add in response to financial innovation and unfolding events. Doing this right required a thoughtful and creative practitioner. Value at Risk, like dynamite, can be a powerful tool when in the right hands. Placed in the wrong hands—well, you know.
These simple models should have been regarded as no more than starting points for serious thinking. Instead, those responsible for making key decisions, institutional investors and their regulators alike, took them literally. This reflected the seductive appeal of elegant theory. Reducing risk to a single number encouraged the belief that it could be mastered. It also made it easier to leave early for that weekend in the Hamptons.
Now, of course, we know that the gulf between assumption and reality was too wide to be bridged. These models were worse than unrealistic. They were weapons of economic mass destruction.
For some years those who relied on these artificial constructs were not caught out. Episodes of high volatility, like the 1987 stock-market crash, still loomed large in the data set to which the model was fit. They served to highlight the potential for big shocks and cautioned against aggressive investment strategies. Since financial innovation was gradual, models estimated on historical data remained reasonable representations of the balance of risks.
WITH TIME, however, memories of the 1987 crash faded. In the data used by the financial engineers, the crash became only one observation among many generated in the course of the Great Moderation. There were echoes, like the all-but-failure of the hedge fund Long-Term Capital Management in 1998. (Over four months the company lost $4.6 billion and had to be saved through a bailout orchestrated by the Federal Reserve Bank of New York.) But these warning signs were muffled by comparison. This encouraged the misplaced belief that the same central-bank policies that had reduced the volatility of inflation had magically, perhaps through transference, also reduced the volatility of financial markets. It encouraged the belief that mastery of the remaining risk made more aggressive investment strategies permissible. It made it possible, for example, to employ more leverage—to make use of more borrowed money—without putting more value at risk.
Meanwhile, deregulation was on the march. Memories of the 1930s disaster that had prompted the adoption of restrictions like the Glass-Steagall Act, which separated commercial and investment banking, faded with the passage of time. This tilted the political balance toward those who, for ideological reasons, favored permissive regulation. Meanwhile, financial institutions, in principle prohibited from pursuing certain lines of business, found ways around those restrictions, encouraging the view that strict regulation was futile. With the elimination of regulatory ceilings on the interest rates that could be paid to depositors, commercial banks had to compete for funding by offering higher rates, which in turn pressured them to adopt riskier lending and investment policies in order to pay the bill. With the entry of low-cost brokerages and the elimination of fixed commissions on stock trades, broker-dealers like Bear Stearns, which had previously earned a comfy living off of such commissions, now felt compelled to enter riskier lines of business.
But where the accelerating pace of change should have prompted more caution, the routinization of risk management encouraged precisely the opposite. The idea that risk management had been reduced to a mere engineering problem seduced business in general, and financial businesses in particular, into believing that it was safe to use more leverage and to invest in more volatile assets.
Of course, risk officers could have pointed out that the models had been fit to data for a period of unprecedented low volatility. They could have pointed out that models designed to predict losses on securities backed by residential mortgages were estimated on data only for years when housing prices were rising and foreclosures were essentially unknown. They could have emphasized the high degree of uncertainty surrounding their estimates. But they knew on which side their bread was buttered. Senior management strongly preferred to take on additional risk, since if the dice came up seven they stood to receive megabonuses, whereas if they rolled snake eyes the worst they could expect was a golden parachute. If an investment strategy that promised high returns today threatened to jeopardize the viability of the enterprise tomorrow, then this was someone else’s problem. For a junior risk officer to warn the members of the investment committee that they were taking undue risk would have dimmed his chances of promotion. And so on up the ladder.
WHY CORPORATE risk officers did not sound the alarm bells is thus clear enough. But where were the business-school professors while these events were unfolding? Answer: they were writing textbooks about Value at Risk. (Truth in advertising requires me to acknowledge that the leading such book is by a professor at the University of California.) Business schools are rated by business publications and compete for students on the basis of their record of placing graduates. With banks hiring graduates educated in Value at Risk, business schools had an obvious incentive to supply the same.
But what of doctoral programs in economics (like the one in which I teach)? The top PhD-granting departments only rarely send their graduates to positions in banking or business—most go on to other universities. But their faculties do not object to the occasional high-paying consulting gig. They don’t mind serving as the entertainment at beachside and ski-slope retreats hosted by investment banks for their important clients.
Generous speaker’s fees were thus available to those prepared to drink the Kool-Aid. Not everyone indulged. But there was nonetheless a subconscious tendency to embrace the arguments of one’s more “successful” colleagues in a discipline where money, in this case earned through speaking engagements and consultancies, is the common denominator of success.
Those who predicted the housing slump eventually became famous, of course. Princeton University Press now takes out space ads in general-interest publications prominently displaying the sober visage of Yale University economics professor Robert Shiller, the maven of the housing crash. Not every academic scribbler can expect this kind of attention from his publisher. But such fame comes only after the fact. The more housing prices rose and the longer predictions of their decline looked to be wrong, the lonelier the intellectual nonconformists became. Sociologists may be more familiar than economists with the psychic costs of nonconformity. But because there is a strong external demand for economists’ services, they may experience even-stronger economic incentives than their colleagues in other disciplines to conform to the industry-held view. They can thus incur even-greater costs—economic and also psychic—from falling out of step.
WHY BELABOR these points? Because it was not that economic theory had nothing to say about the kinds of structural weaknesses and conflicts of interest that paved the way to our current catastrophe. In fact, large swaths of modern economic theory focus squarely on the kind of generic problems that created our current mess. The problem was not an inability to imagine that conflicts of interest, self-dealing and herd behavior could arise, but a peculiar failure to apply those insights to the real world.
Take for example agency theory, whose point of departure is the observation that shareholders find it difficult to monitor managers, who have an incentive to make decisions that translate into large end-of-current-year bonuses but not necessarily into the long-term health of the enterprise. Risk taking that produces handsome returns today but ends in bankruptcy tomorrow may be perfectly congenial to CEOs who receive generous bonuses and severance packages but not to shareholders who end up holding worthless paper. This work had long pointed to compensation practices in the financial sector as encouraging short-termism and excessive risk taking and heightening conflicts of interest. The failure to heed such warnings is all the more striking given that agency theory is hardly an obscure corner of economics. A Nobel Prize for work on this topic was awarded to Leonid Hurwicz, Eric Maskin and Roger Myerson in 2007. (So much for the idea that it is only the financial engineers who are recognized by the Nobel Committee.)
Then there is information economics. It is a fact of life that borrowers know more than lenders about their willingness and capacity to repay. Who could know better what motivation lurks in the mind of the borrower and what opportunities he truly possesses? Taking this observation as its starting point, research in information economics has long emphasized the existence of adverse selection in financial markets—when interest rates rise, only borrowers with high-risk projects offering some chance of generating the high returns needed to service and repay loans will be willing to borrow. Indeed, if higher interest rates mean riskier borrowers, there may be no interest rate high enough to compensate the lender for the risk that the borrower may default. In that case lending and borrowing may collapse.
These models also show how borrowers have an incentive to take on more risk when using other people’s money or if they expect to be bailed out when things go wrong. In the wake of recent financial rescues, the name for this problem, “moral hazard,” will be familiar to even the casual newspaper reader. Again this is hardly an obscure corner of economics: George Akerlof, Michael Spence and Joseph Stiglitz were awarded the Nobel Prize for their work on it in 2001. Here again the potential problems of an inadequately regulated financial system would have been quite clear had anyone bothered to look.
Finally there is behavioral economics and its applications, including behavioral finance. Behavioral economics focuses on how cognition, emotion, and other psychological and social factors affect economic and financial decision making. Behavioral economists depart from the simpleminded benchmark that all investors take optimal decisions on the basis of all available information. Instead they acknowledge that decision making is not easy. They acknowledge that many decisions are taken using rules of thumb, which are often formed on the basis of social convention. They analyze how, to pick an example not entirely at random, decision making can be affected by the psychic costs of nonconformity.
It is easy to see how this small step in the direction of realism can transform one’s view of financial markets. It can explain herd behavior, where everyone follows the crowd, giving rise to bubbles, panics and crashes. Economists have succeeded in building elegant mathematical models of decision making under these conditions and in showing how such behavior can give rise to extreme instability. It should not be a surprise that people like the aforementioned George Akerlof and Robert Shiller are among the leaders in this field.
Moreover, what is true of investors can also be true of regulators, for whom information is similarly costly to acquire and who will similarly be tempted to follow convention—even when that convention allows excessive risk taking by the regulated. Indeed, these theories suggest that the attitudes of regulators may be infected not merely by the practices and attitudes of their fellow regulators, but also by those of the regulated. Economists now even have a name for this particular version of the intellectual fox-in-the-henhouse syndrome: cognitive regulatory capture.
And what is true of investors and regulators, introspection suggests, can also be true of academics. When it is costly to acquire and assimilate information about how reality diverges from the assumptions underlying popular economic models, it will be tempting to ignore those divergences. When convention within the discipline is to assume efficient markets, there will be psychic costs if one attempts to buck the trend. Scholars, in other words, are no more immune than regulators to the problem of cognitive capture.
What got us into this mess, in other words, were not the limits of scholarly imagination. It was not the failure or inability of economists to model conflicts of interest, incentives to take excessive risk and information problems that can give rise to bubbles, panics and crises. It was not that economists failed to recognize the role of social and psychological factors in decision making or that they lacked the tools needed to draw out the implications. In fact, these observations and others had been imaginatively elaborated by contributors to the literatures on agency theory, information economics and behavioral finance. Rather, the problem was a partial and blinkered reading of that literature. The consumers of economic theory, not surprisingly, tended to pick and choose those elements of that rich literature that best supported their self-serving actions. Equally reprehensibly, the producers of that theory, benefiting in ways both pecuniary and psychic, showed disturbingly little tendency to object. It is in this light that we must understand how it was that the vast majority of the economics profession remained so blissfully silent and indeed unaware of the risk of financial disaster.
WITH THE pressure of social conformity being so powerful, are we economists doomed to repeat past mistakes? Will we forever follow the latest intellectual fad and fashion, swinging wildly—much like investors whose behavior we seek to model—from irrational exuberance to excessive despair about the operation of markets? Isn’t our outlook simply too erratic and advice therefore too unreliable to be trusted as a guide for policy?
Maybe so. But amid the pervading sense of gloom and doom, there is at least one reason for hope. The last ten years have seen a quiet revolution in the practice of economics. For years theorists held the intellectual high ground. With their mastery of sophisticated mathematics, they were the high-prestige members of the profession. The methods of empirical economists seeking to analyze real data were rudimentary by comparison. As recently as the 1970s, doing a statistical analysis meant entering data on punch cards, submitting them at the university computing center, going out for dinner and returning some hours later to see if the program had successfully run. (I speak from experience.) The typical empirical analysis in economics utilized a few dozen, or at most a few hundred, observations transcribed by hand. It is not surprising that the theoretically inclined looked down, fondly if a bit condescendingly, on their more empirically oriented colleagues or that the theorists ruled the intellectual roost.
But the IT revolution has altered the lay of the intellectual land. Now every graduate student has a laptop computer with more memory than that decades-old university computing center. And she knows what to do with it. Just like the typical twelve-year-old knows more than her parents about how to download data from the internet, for graduate students in economics, unlike their instructors, importing data from cyberspace is second nature. They can grab data on grocery-store spending generated by the club cards issued by supermarket chains and combine it with information on temperature by zip code to see how the weather affects sales of beer. Their next step, of course, is to download securities prices from Bloomberg and see how blue skies and rain affect the behavior of financial markets. Finding that stock markets are more likely to rise on sunny days is not exactly reassuring for believers in the efficient-markets hypothesis.
The data sets used in empirical economics today are enormous, with observations running into the millions. Some of this work is admittedly self-indulgent, with researchers seeking to top one another in applying the largest data set to the smallest problem. But now it is on the empirical side where the capacity to do high-quality research is expanding most dramatically, be the topic beer sales or asset pricing. And, revealingly, it is now empirically oriented graduate students who are the hot property when top doctoral programs seek to hire new faculty.
Not surprisingly, the best students have responded. The top young economists are, increasingly, empirically oriented. They are concerned not with theoretical flights of fancy but with the facts on the ground. To the extent that their work is rooted concretely in observation of the real world, it is less likely to sway with the latest fad and fashion. Or so one hopes.
The late twentieth century was the heyday of deductive economics. Talented and facile theorists set the intellectual agenda. Their very facility enabled them to build models with virtually any implication, which meant that policy makers could pick and choose at their convenience. Theory turned out to be too malleable, in other words, to provide reliable guidance for policy.
In contrast, the twenty-first century will be the age of inductive economics, when empiricists hold sway and advice is grounded in concrete observation of markets and their inhabitants. Work in economics, including the abstract model building in which theorists engage, will be guided more powerfully by this real-world observation. It is about time.
Should this reassure us that we can avoid another crisis? Alas, there is no such certainty. The only way of being certain that one will not fall down the stairs is to not get out of bed. But at least economists, having observed the history of accidents, will no longer recommend removing the handrail.
Barry Eichengreen is the George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California, Berkeley.
04.30.2009
From the May/June 2009 issue of The National Interest.
THE GREAT Credit Crisis has cast into doubt much of what we thought we knew about economics. We thought that monetary policy had tamed the business cycle. We thought that because changes in central-bank policies had delivered low and stable inflation, the volatility of the pre-1985 years had been consigned to the dustbin of history; they had given way to the quaintly dubbed “Great Moderation.” We thought that financial institutions and markets had come to be self-regulating—that investors could be left largely if not wholly to their own devices. Above all we thought that we had learned how to prevent the kind of financial calamity that struck the world in 1929.
We now know that much of what we thought was true was not. The Great Moderation was an illusion. Monetary policies focusing on low inflation to the exclusion of other considerations (not least excesses in financial markets) can allow dangerous vulnerabilities to build up. Relying on institutional investors to self-regulate is the economic equivalent of letting children decide their own diets. As a result we are now in for an economic and financial downturn that will rival the Great Depression before it is over.
The question is how we could have been so misguided. One interpretation, understandably popular given our current plight, is that the basic economic theory informing the actions of central bankers and regulators was fatally flawed. The only course left is to throw it out and start over. But another view, considerably closer to the truth, is that the problem lay not so much with the poverty of the underlying theory as with selective reading of it—a selective reading shaped by the social milieu. That social milieu encouraged financial decision makers to cherry-pick the theories that supported excessive risk taking. It discouraged whistle-blowing, not just by risk-management officers in large financial institutions, but also by the economists whose scholarship provided intellectual justification for the financial institutions’ decisions. The consequence was that scholarship that warned of potential disaster was ignored. And the result was global economic calamity on a scale not seen for four generations.
SO WHERE were the intellectual agenda setters when the crisis was building? Why did they fail to see this train wreck coming? More than that, why did they consort actively with the financial sector in setting the stage for the collapse?
For economists in business schools the answer is straightforward. Business schools see themselves as suppliers of inputs to business. Just as General Motors provides its suppliers with specifications for the cold-rolled sheet it needs for fabricating auto bodies, J. P. Morgan makes clear the kind of financial engineers it requires, and business schools deem to provide. In the wake of the 1987 stock-market crash, Morgan’s chairman, Dennis Weatherstone, started calling for a daily “4:15 Report” summarizing how much his firm would lose if tomorrow turned out to be a bad day. His counterparts at other firms then adopted the practice. Soon after, business schools jumped to supply graduates to write those reports. Value at Risk, as that number and the process for calculating it came to be known, quickly gained a place in the business-school curriculum.
The desire for up-to-date information on the risks of doing business was admirable. Less admirable was the belief that those risks could be reduced to a single number which could then be estimated on the basis of a set of mathematical equations fitted to a few data points. Much as former–GM CEO Alfred Sloan once sought to transform automobile production from a craft to an engineering problem, Weatherstone and his colleagues encouraged the belief that risk and return could be reduced to a set of equations specified by an MBA and solved by a machine.
Getting the machine to spit out a headline number for Value at Risk was straightforward. But deciding what to put into the model was another matter. The art of gauging Value at Risk required imagining the severity of the shocks to which the portfolio might be subjected. It required knowing what new variables to add in response to financial innovation and unfolding events. Doing this right required a thoughtful and creative practitioner. Value at Risk, like dynamite, can be a powerful tool when in the right hands. Placed in the wrong hands—well, you know.
These simple models should have been regarded as no more than starting points for serious thinking. Instead, those responsible for making key decisions, institutional investors and their regulators alike, took them literally. This reflected the seductive appeal of elegant theory. Reducing risk to a single number encouraged the belief that it could be mastered. It also made it easier to leave early for that weekend in the Hamptons.
Now, of course, we know that the gulf between assumption and reality was too wide to be bridged. These models were worse than unrealistic. They were weapons of economic mass destruction.
For some years those who relied on these artificial constructs were not caught out. Episodes of high volatility, like the 1987 stock-market crash, still loomed large in the data set to which the model was fit. They served to highlight the potential for big shocks and cautioned against aggressive investment strategies. Since financial innovation was gradual, models estimated on historical data remained reasonable representations of the balance of risks.
WITH TIME, however, memories of the 1987 crash faded. In the data used by the financial engineers, the crash became only one observation among many generated in the course of the Great Moderation. There were echoes, like the all-but-failure of the hedge fund Long-Term Capital Management in 1998. (Over four months the company lost $4.6 billion and had to be saved through a bailout orchestrated by the Federal Reserve Bank of New York.) But these warning signs were muffled by comparison. This encouraged the misplaced belief that the same central-bank policies that had reduced the volatility of inflation had magically, perhaps through transference, also reduced the volatility of financial markets. It encouraged the belief that mastery of the remaining risk made more aggressive investment strategies permissible. It made it possible, for example, to employ more leverage—to make use of more borrowed money—without putting more value at risk.
Meanwhile, deregulation was on the march. Memories of the 1930s disaster that had prompted the adoption of restrictions like the Glass-Steagall Act, which separated commercial and investment banking, faded with the passage of time. This tilted the political balance toward those who, for ideological reasons, favored permissive regulation. Meanwhile, financial institutions, in principle prohibited from pursuing certain lines of business, found ways around those restrictions, encouraging the view that strict regulation was futile. With the elimination of regulatory ceilings on the interest rates that could be paid to depositors, commercial banks had to compete for funding by offering higher rates, which in turn pressured them to adopt riskier lending and investment policies in order to pay the bill. With the entry of low-cost brokerages and the elimination of fixed commissions on stock trades, broker-dealers like Bear Stearns, which had previously earned a comfy living off of such commissions, now felt compelled to enter riskier lines of business.
But where the accelerating pace of change should have prompted more caution, the routinization of risk management encouraged precisely the opposite. The idea that risk management had been reduced to a mere engineering problem seduced business in general, and financial businesses in particular, into believing that it was safe to use more leverage and to invest in more volatile assets.
Of course, risk officers could have pointed out that the models had been fit to data for a period of unprecedented low volatility. They could have pointed out that models designed to predict losses on securities backed by residential mortgages were estimated on data only for years when housing prices were rising and foreclosures were essentially unknown. They could have emphasized the high degree of uncertainty surrounding their estimates. But they knew on which side their bread was buttered. Senior management strongly preferred to take on additional risk, since if the dice came up seven they stood to receive megabonuses, whereas if they rolled snake eyes the worst they could expect was a golden parachute. If an investment strategy that promised high returns today threatened to jeopardize the viability of the enterprise tomorrow, then this was someone else’s problem. For a junior risk officer to warn the members of the investment committee that they were taking undue risk would have dimmed his chances of promotion. And so on up the ladder.
WHY CORPORATE risk officers did not sound the alarm bells is thus clear enough. But where were the business-school professors while these events were unfolding? Answer: they were writing textbooks about Value at Risk. (Truth in advertising requires me to acknowledge that the leading such book is by a professor at the University of California.) Business schools are rated by business publications and compete for students on the basis of their record of placing graduates. With banks hiring graduates educated in Value at Risk, business schools had an obvious incentive to supply the same.
But what of doctoral programs in economics (like the one in which I teach)? The top PhD-granting departments only rarely send their graduates to positions in banking or business—most go on to other universities. But their faculties do not object to the occasional high-paying consulting gig. They don’t mind serving as the entertainment at beachside and ski-slope retreats hosted by investment banks for their important clients.
Generous speaker’s fees were thus available to those prepared to drink the Kool-Aid. Not everyone indulged. But there was nonetheless a subconscious tendency to embrace the arguments of one’s more “successful” colleagues in a discipline where money, in this case earned through speaking engagements and consultancies, is the common denominator of success.
Those who predicted the housing slump eventually became famous, of course. Princeton University Press now takes out space ads in general-interest publications prominently displaying the sober visage of Yale University economics professor Robert Shiller, the maven of the housing crash. Not every academic scribbler can expect this kind of attention from his publisher. But such fame comes only after the fact. The more housing prices rose and the longer predictions of their decline looked to be wrong, the lonelier the intellectual nonconformists became. Sociologists may be more familiar than economists with the psychic costs of nonconformity. But because there is a strong external demand for economists’ services, they may experience even-stronger economic incentives than their colleagues in other disciplines to conform to the industry-held view. They can thus incur even-greater costs—economic and also psychic—from falling out of step.
WHY BELABOR these points? Because it was not that economic theory had nothing to say about the kinds of structural weaknesses and conflicts of interest that paved the way to our current catastrophe. In fact, large swaths of modern economic theory focus squarely on the kind of generic problems that created our current mess. The problem was not an inability to imagine that conflicts of interest, self-dealing and herd behavior could arise, but a peculiar failure to apply those insights to the real world.
Take for example agency theory, whose point of departure is the observation that shareholders find it difficult to monitor managers, who have an incentive to make decisions that translate into large end-of-current-year bonuses but not necessarily into the long-term health of the enterprise. Risk taking that produces handsome returns today but ends in bankruptcy tomorrow may be perfectly congenial to CEOs who receive generous bonuses and severance packages but not to shareholders who end up holding worthless paper. This work had long pointed to compensation practices in the financial sector as encouraging short-termism and excessive risk taking and heightening conflicts of interest. The failure to heed such warnings is all the more striking given that agency theory is hardly an obscure corner of economics. A Nobel Prize for work on this topic was awarded to Leonid Hurwicz, Eric Maskin and Roger Myerson in 2007. (So much for the idea that it is only the financial engineers who are recognized by the Nobel Committee.)
Then there is information economics. It is a fact of life that borrowers know more than lenders about their willingness and capacity to repay. Who could know better what motivation lurks in the mind of the borrower and what opportunities he truly possesses? Taking this observation as its starting point, research in information economics has long emphasized the existence of adverse selection in financial markets—when interest rates rise, only borrowers with high-risk projects offering some chance of generating the high returns needed to service and repay loans will be willing to borrow. Indeed, if higher interest rates mean riskier borrowers, there may be no interest rate high enough to compensate the lender for the risk that the borrower may default. In that case lending and borrowing may collapse.
These models also show how borrowers have an incentive to take on more risk when using other people’s money or if they expect to be bailed out when things go wrong. In the wake of recent financial rescues, the name for this problem, “moral hazard,” will be familiar to even the casual newspaper reader. Again this is hardly an obscure corner of economics: George Akerlof, Michael Spence and Joseph Stiglitz were awarded the Nobel Prize for their work on it in 2001. Here again the potential problems of an inadequately regulated financial system would have been quite clear had anyone bothered to look.
Finally there is behavioral economics and its applications, including behavioral finance. Behavioral economics focuses on how cognition, emotion, and other psychological and social factors affect economic and financial decision making. Behavioral economists depart from the simpleminded benchmark that all investors take optimal decisions on the basis of all available information. Instead they acknowledge that decision making is not easy. They acknowledge that many decisions are taken using rules of thumb, which are often formed on the basis of social convention. They analyze how, to pick an example not entirely at random, decision making can be affected by the psychic costs of nonconformity.
It is easy to see how this small step in the direction of realism can transform one’s view of financial markets. It can explain herd behavior, where everyone follows the crowd, giving rise to bubbles, panics and crashes. Economists have succeeded in building elegant mathematical models of decision making under these conditions and in showing how such behavior can give rise to extreme instability. It should not be a surprise that people like the aforementioned George Akerlof and Robert Shiller are among the leaders in this field.
Moreover, what is true of investors can also be true of regulators, for whom information is similarly costly to acquire and who will similarly be tempted to follow convention—even when that convention allows excessive risk taking by the regulated. Indeed, these theories suggest that the attitudes of regulators may be infected not merely by the practices and attitudes of their fellow regulators, but also by those of the regulated. Economists now even have a name for this particular version of the intellectual fox-in-the-henhouse syndrome: cognitive regulatory capture.
And what is true of investors and regulators, introspection suggests, can also be true of academics. When it is costly to acquire and assimilate information about how reality diverges from the assumptions underlying popular economic models, it will be tempting to ignore those divergences. When convention within the discipline is to assume efficient markets, there will be psychic costs if one attempts to buck the trend. Scholars, in other words, are no more immune than regulators to the problem of cognitive capture.
What got us into this mess, in other words, were not the limits of scholarly imagination. It was not the failure or inability of economists to model conflicts of interest, incentives to take excessive risk and information problems that can give rise to bubbles, panics and crises. It was not that economists failed to recognize the role of social and psychological factors in decision making or that they lacked the tools needed to draw out the implications. In fact, these observations and others had been imaginatively elaborated by contributors to the literatures on agency theory, information economics and behavioral finance. Rather, the problem was a partial and blinkered reading of that literature. The consumers of economic theory, not surprisingly, tended to pick and choose those elements of that rich literature that best supported their self-serving actions. Equally reprehensibly, the producers of that theory, benefiting in ways both pecuniary and psychic, showed disturbingly little tendency to object. It is in this light that we must understand how it was that the vast majority of the economics profession remained so blissfully silent and indeed unaware of the risk of financial disaster.
WITH THE pressure of social conformity being so powerful, are we economists doomed to repeat past mistakes? Will we forever follow the latest intellectual fad and fashion, swinging wildly—much like investors whose behavior we seek to model—from irrational exuberance to excessive despair about the operation of markets? Isn’t our outlook simply too erratic and advice therefore too unreliable to be trusted as a guide for policy?
Maybe so. But amid the pervading sense of gloom and doom, there is at least one reason for hope. The last ten years have seen a quiet revolution in the practice of economics. For years theorists held the intellectual high ground. With their mastery of sophisticated mathematics, they were the high-prestige members of the profession. The methods of empirical economists seeking to analyze real data were rudimentary by comparison. As recently as the 1970s, doing a statistical analysis meant entering data on punch cards, submitting them at the university computing center, going out for dinner and returning some hours later to see if the program had successfully run. (I speak from experience.) The typical empirical analysis in economics utilized a few dozen, or at most a few hundred, observations transcribed by hand. It is not surprising that the theoretically inclined looked down, fondly if a bit condescendingly, on their more empirically oriented colleagues or that the theorists ruled the intellectual roost.
But the IT revolution has altered the lay of the intellectual land. Now every graduate student has a laptop computer with more memory than that decades-old university computing center. And she knows what to do with it. Just like the typical twelve-year-old knows more than her parents about how to download data from the internet, for graduate students in economics, unlike their instructors, importing data from cyberspace is second nature. They can grab data on grocery-store spending generated by the club cards issued by supermarket chains and combine it with information on temperature by zip code to see how the weather affects sales of beer. Their next step, of course, is to download securities prices from Bloomberg and see how blue skies and rain affect the behavior of financial markets. Finding that stock markets are more likely to rise on sunny days is not exactly reassuring for believers in the efficient-markets hypothesis.
The data sets used in empirical economics today are enormous, with observations running into the millions. Some of this work is admittedly self-indulgent, with researchers seeking to top one another in applying the largest data set to the smallest problem. But now it is on the empirical side where the capacity to do high-quality research is expanding most dramatically, be the topic beer sales or asset pricing. And, revealingly, it is now empirically oriented graduate students who are the hot property when top doctoral programs seek to hire new faculty.
Not surprisingly, the best students have responded. The top young economists are, increasingly, empirically oriented. They are concerned not with theoretical flights of fancy but with the facts on the ground. To the extent that their work is rooted concretely in observation of the real world, it is less likely to sway with the latest fad and fashion. Or so one hopes.
The late twentieth century was the heyday of deductive economics. Talented and facile theorists set the intellectual agenda. Their very facility enabled them to build models with virtually any implication, which meant that policy makers could pick and choose at their convenience. Theory turned out to be too malleable, in other words, to provide reliable guidance for policy.
In contrast, the twenty-first century will be the age of inductive economics, when empiricists hold sway and advice is grounded in concrete observation of markets and their inhabitants. Work in economics, including the abstract model building in which theorists engage, will be guided more powerfully by this real-world observation. It is about time.
Should this reassure us that we can avoid another crisis? Alas, there is no such certainty. The only way of being certain that one will not fall down the stairs is to not get out of bed. But at least economists, having observed the history of accidents, will no longer recommend removing the handrail.
Barry Eichengreen is the George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California, Berkeley.
How did Paul Krugman get it so wrong?
How did Paul Krugman get it so Wrong?
John H. Cochrane*
Many friends and colleagues have asked me what I think of Paul Krugman’s New York Times Magazine article, “How did Economists get it so wrong?”
Most of all, it’s sad. Imagine this weren’t economics for a moment. Imagine this were a respected scientist turned popular writer, who says, most basically, that everything everyone has done in his field since the mid 1960s is a complete waste of time. Everything that fills its academic journals, is taught in its PhD programs, presented at its conferences, summarized in its graduate textbooks, and rewarded with the accolades a profession can bestow, including multiple Nobel prizes, is totally wrong. Instead, he calls for a return to the eternal verities of a rather convoluted book written in the 1930s, as taught to our author in his undergraduate introductory courses. If a scientist, he might be a global-warming skeptic, an AIDS-HIV disbeliever, a creationist, a stalwart that maybe continents don’t move after all.
It gets worse. Krugman hints at dark conspiracies, claiming “dissenters are marginalized.” Most of the article is just a calumnious personal attack on an ever-growing enemies list, which now includes “new Keyenesians” such as Olivier Blanchard and Greg Mankiw. Rather than source professional writing, he plays gotcha with out-of-context second-hand quotes from media interviews. He makes stuff up, boldly putting words in people’s mouths that run contrary to their written opinions. Even this isn’t enough: he adds cartoons to try to make his “enemies” look silly, and puts them in false and embarrassing situations. He accuses us of adopting ideas for pay, selling out for “sabbaticals at the Hoover institution” and fat “Wall street paychecks.” It sounds a bit paranoid.
It’s annoying to the victims, but we’re big boys and girls. It’s a disservice to New York Times readers. They depend on Krugman to read real academic literature and digest it, and they get this attack instead. And it’s ineffective. Any astute reader knows that personal attacks and innuendo mean the author has run out of ideas.
That’s the biggest and saddest news of this piece: Paul Krugman has no interesting ideas whatsoever about what caused our current financial and economic problems, what policies might have prevented it, or what might help us in the future, and he has no contact with people who do. “Irrationality” and advice to spend like a drunken sailor are pretty superficial compared to all the fascinating things economists are writing about it these days.
How sad.
That’s what I think, but I don’t expect you the reader to be convinced by my opinion or my reference to professional consensus. Maybe he is right. Occasionally sciences, especially social sciences, do take a wrong turn for a decade or two. I thought Keynesian economics was such a wrong turn. So let’s take a quick look at the ideas.
Krugman’s attack has two goals. First, he thinks financial markets are “inefficient,” fundamentally due to “irrational” investors, and thus prey to excessive volatility which needs government control. Second, he likes the huge “fiscal stimulus” provided by multi-trillion dollar deficits.
Efficiency.
It’s fun to say we didn’t see the crisis coming, but the central empirical prediction of the efficient markets hypothesis is precisely that nobody can tell where markets are going – neither benevolent government bureaucrats, nor crafty hedge-fund managers, nor ivory-tower academics. This is probably the best-tested proposition in all the social sciences. Krugman knows this, so all he can do is huff and puff about his dislike for a theory whose central prediction is that nobody can be a reliable soothsayer.
Krugman writes as if the volatility of stock prices alone disproves market efficiency, and efficient marketers just ignored it all these years. This is a canard that Paul knows better than to pass on, no matter how rhetorically convenient. (I can overlook his mixing up the CAPM and Black-Scholes model, but not this.) There is nothing about “efficiency” that promises “stability.” “Stable” growth would in fact be a major violation of efficiency. Efficient markets did not need to wait for “the memory of 1929 … gradually receding,” nor did we fail to read the newspapers in 1987. Data from the great depression has been included in practically all the tests. In fact, the great “equity premium puzzle” is that if efficient, stock markets don’t seem risky enough to deter more people from investing! Gene Fama’s PhD thesis was on “fat tails” in stock returns.
It is true and very well documented that asset prices move more than reasonable expectations of future cashflows. This might be because people are prey to bursts of irrational optimism and pessimism. It might also be because people’s willingness to take on risk varies over time, and is lower in bad economic times. As Gene Fama pointed out in 1970, these are observationally equivalent explanations. Unless you are willing to elaborate your theory to the point that it can quantitatively describe how much and when risk premiums, or waves of “optimism” and “pessimism,” can vary, you know nothing. No theory is particularly good at that right now.
Crying “bubble” is empty unless you have an operational procedure for identifying bubbles, distinguishing them from rationally low risk premiums, and not crying wolf too many years in a row. Krugman rightly praises Robert Shiller for his warnings over many years that house prices might fall. But advice that we should listen to Shiller, because he got the last one right, is no more useful than previous advice from many quarters to listen to Greenspan because he got several ones right. Following the last mystic oracle until he gets one wrong, then casting him to the wolves, is not a good long-term strategy for identifying bubbles. Krugman likes Shiller because he advocates behavioral ideas, but that’s no help either. People who call themselves behavioral have just as wide a divergence of opinion as those who don’t. Are markets irrationally exuberant or irrationally depressed? It’s hard to tell.
This difficulty is no surprise. It’s the central prediction of free-market economics, as crystallized by Hayek, that no academic, bureaucrat or regulator will ever be able to fully explain market price movements. Nobody knows what “fundamental” value is. If anyone could tell what the price of tomatoes should be, let alone the price of Microsoft stock, communism would have worked.
More deeply, the economist’s job is not to “explain” market fluctuations after the fact, to give a pleasant story on the evening news about why markets went up or down. Markets up? “A wave of positive sentiment.” Markets went down? “Irrational pessimism.” ( “The risk premium must have increased” is just as empty.) Our ancestors could do that. Really, is that an improvement on “Zeus had a fight with Apollo?” Good serious behavioral economists know this, and they are circumspect in their explanatory claims so far.
But this argument takes us away from the main point. The case for free markets never was that markets are perfect. The case for free markets is that government control of markets, especially asset markets, has always been much worse.
Krugman at bottom is arguing that the government should massively intervene in financial markets, and take charge of the allocation of capital. He can’t quite come out and say this, but he does say “Keynes considered it a very bad idea to let such markets…dictate important business decisions,” and “finance economists believed that we should put the capital development of the nation in the hands of what Keynes had called a `casino.’” Well, if markets can’t be trusted to allocate capital, we don’t have to connect too many dots to imagine who Paul has in mind.
To reach this conclusion, you need evidence, experience, or any realistic hope that the alternative will be better. Remember, the SEC couldn’t even find Bernie Madoff when he was handed to them on a silver platter. Think of the great job Fannie, Freddie, and Congress did in the mortgage market. Is this system going to regulate Citigroup, guide financial markets to the right price, replace the stock market, and tell our society which new products are worth investment? As David Wessel’s excellent In Fed We Trust makes perfectly clear, government regulators failed just as abysmally as private investors and economists to see the storm coming. And not from any lack of smarts.
In fact, the behavioral view gives us a new and stronger argument against regulation and control. Regulators are just as human and irrational as market participants. If bankers are, in Krugman’s words, “idiots,” then so must be the typical treasury secretary, fed chairman, and regulatory staff. They act alone or in committees, where behavioral biases are much better documented than in market settings. They are still easily captured by industries, and face politically distorted incentives.
Careful behavioralists know this, and do not quickly run from “the market got it wrong” to “the government can put it all right.” Even my most behavioral colleagues Richard Thaler and Cass Sunstein in their book “Nudge” go only so far as a light libertarian paternalism, suggesting good default options on our 401(k) accounts. (And even here they’re not very clear on how the Federal Nudging Agency is going to steer clear of industry capture.) They don’t even think of jumping from irrational markets, which they believe in deeply, to Federal control of stock and house prices and allocation of capital.
Stimulus
Most of all, Krugman likes fiscal stimulus. In this quest, he accuses us and the rest of the economics profession of “mistaking beauty for truth.” He’s not clear on what the “beauty” is that we all fell in love with, and why one should shun it, for good reason. The first siren of beauty is simple logical consistency. Paul’s Keynesian economics requires that people make logically inconsistent plans to consume more, invest more, and pay more taxes with the same income. The second siren is plausible assumptions about how people behave. Keynesian economics requires that the government is able to systematically fool people again and again. It presumes that people don’t think about the future in making decisions today. Logical consistency and plausible foundations are indeed “beautiful” but to me they are also basic preconditions for “truth.”
In economics, stimulus spending ran aground on Robert Barro’s Ricardian equivalence theorem. This theorem says that debt-financed spending can’t have any effect because people, seeing the higher future taxes that must pay off the debt, will simply save more. They will buy the new government debt and leave all spending decisions unaltered. Is this theorem true? It’s a logical connection from a set of “if” to a set of “therefore.” Not even Paul can object to the connection.
Therefore, we have to examine the “ifs.” And those ifs are, as usual, obviously not true. For example, the theorem presumes lump-sum taxes, not proportional income taxes. Alas, when you take this into account we are all made poorer by deficit spending, so the multiplier is most likely negative. The theorem (like most Keynesian economics) ignores the composition of output; but surely spending money on roads rather than cars can affect the overall level.
Economists have spent a generation tossing and turning the Ricardian equivalence theorem, and assessing the likely effects of fiscal stimulus in its light, generalizing the “ifs” and figuring out the likely “therefores.” This is exactly the right way to do things. The impact of Ricardian equivalence is not that this simple abstract benchmark is literally true. The impact is that in its wake, if you want to understand the effects of government spending, you have to specify why it is false. Doing so does not lead you anywhere near old-fashioned Keynesian economics. It leads you to consider distorting taxes, how much people care about their children, how many people would like to borrow more to finance today’s consumption and so on. And when you find “market failures” that might justify a multiplier, optimal-policy analysis suggests fixing the market failures, not their exploitation by fiscal multiplier. Most “New Keynesian” analyses that add frictions don’t produce big multipliers.
This is how real thinking about stimulus actually proceeds. Nobody ever “asserted that an increase in government spending cannot, under any circumstances, increase employment.” This is unsupportable by any serious review of professional writings, and Krugman knows it. (My own are perfectly clear on lots of possibilities for an answer that is not zero.) But thinking through this sort of thing and explaining it is much harder than just tarring your enemies with out-of-context quotes, ethical innuendo, or silly cartoons.
In fact, I propose that Krugman himself doesn’t really believe the Keynesian logic for that stimulus. I doubt he would follow that logic to its inevitable conclusions. Stimulus must have some other attraction to him.
If you believe the Keynesian argument for stimulus, you should think Bernie Madoff is a hero. He took money from people who were saving it, and gave it to people who most assuredly were going to spend it. Each dollar so transferred, in Krugman’s world, generates an additional dollar and a half of national income. The analogy is even closer. Madoff didn’t just take money from his savers, he essentially borrowed it from them, giving them phony accounts with promises of great profits to come. This looks a lot like government debt.
If you believe the Keynesian argument for stimulus, you don’t care how the money is spent. All this puffery about “infrastructure,” monitoring, wise investment, jobs “created” and so on is pointless. Keynes thought the government should pay people to dig ditches and fill them up.
If you believe in Keynesian stimulus, you don’t even care if the government spending money is stolen. Actually, that would be better. Thieves have notoriously high propensities to consume.
The crash.
Krugman’s article is supposedly about how the crash and recession changed our thinking, and what economics has to say about it. The most amazing news in the whole article is that Paul Krugman has absolutely no idea about what caused the crash, what policies might have prevented it, and what policies we should adopt going forward. He seems completely unaware of the large body of work by economists who actually do know something about the banking and financial system, and have been thinking about it productively for a generation.
Here’s all he has to say: “Irrationality” caused markets to go up and then down. “Spending” then declined, for unclear reasons, possibly “irrational” as well. The sum total of his policy recommendations is for the Federal Government to spend like a drunken sailor after the fact.
Paul, there was a financial crisis, a classic near-run on banks. The centerpiece of our crash was not the relatively free stock or real estate markets, it was the highly regulated commercial banks. A generation of economists has thought really hard about these kinds of events. Look up Diamond, Rajan, Gorton, Kashyap, Stein, and so on. They’ve thought about why there is so much short term debt, why banks run, how deposit insurance and credit guarantees help, and how they give incentives for excessive risk taking.
If we want to think about events and policies, this seems like more than a minor detail. The hard and central policy debate over the last year was how to manage this financial crisis. Now it is how to set up the incentives of banks and other financial institutions so this mess doesn’t happen again. There’s lots of good and subtle economics here that New York Times readers might like to know about. What does Krugman have to say? Zero.
Krugman doesn’t even have anything to say about the Fed. Ben Bernanke did a lot more last year than set the funds rate to zero and then go off on vacation and wait for fiscal policy to do its magic. Leaving aside the string of bailouts, the Fed started term lending to securities dealers. Then, rather than buy treasuries in exchange for reserves, it essentially sold treasuries in exchange for private debt. Though the funds rate was near zero, the Fed noticed huge commercial paper and securitized debt spreads, and intervened in those markets. There is no “the” interest rate anymore, the Fed is attempting to manage them all. Recently the Fed has started buying massive quantities of mortgage-backed securities and long-term treasury debt.
Monetary policy now has little to do with “money” vs. “bonds” with all the latter lumped together. Monetary policy has become wide-ranging financial policy. Does any of this work? What are the dangers? Can the Fed stay independent in this new role? These are the questions of our time. What does Krugman have to say? Nothing.
Krugman is trying to say that a cabal of obvious crackpots bedazzled all of macroeconomics with the beauty of their mathematics, to the point of inducing policy paralysis. Alas, that won’t stick. The sad fact is that few in Washington pay the slightest attention to modern macroeconomic research, in particular anything with a serious intertemporal dimension. Paul’s simple Keynesianism has dominated policy analysis for decades and continues to do so. From the CEA to the Fed to the OMB and CBO, everyone just adds up consumer, investment and government “demand” to forecast output and uses simple Phillips curves to think about inflation. If a failure of ideas caused bad policy, it’s a simpleminded Keynesianism that failed.
The future of economics.
How should economics change? Krugman argues for three incompatible changes.
First, he argues for a future of economics that “recognizes flaws and frictions,” and incorporates alternative assumptions about behavior, especially towards risk-taking. To which I say, “Hello, Paul, where have you been for the last 30 years?” Macroeconomists have not spent 30 years admiring the eternal verities of Kydland and Prescott’s 1982 paper. Pretty much all we have been doing for 30 years is introducing flaws, frictions and new behaviors, especially new models of attitudes to risk, and comparing the resulting models, quantitatively, to data. The long literature on financial crises and banking which Krugman does not mention has also been doing exactly the same.
Second, Krugman argues that “a more or less Keynesian view is the only plausible game in town,” and “Keynesian economics remains the best framework we have for making sense of recessions and depressions.” One thing is pretty clear by now, that when economics incorporates flaws and frictions, the result will not be to rehabilitate an 80-year-old book. As Paul bemoans, the “new Keynesians” who did just what he asks, putting Keynes inspired price-stickiness into logically coherent models, ended up with something that looked a lot more like monetarism. (Actually, though this is the consensus, my own work finds that new-Keynesian economics ended up with something much different and more radical than monetarism.) A science that moves forward almost never ends up back where it started. Einstein revises Newton, but does not send you back to Aristotle. At best you can play the fun game of hunting for inspirational quotes, but that doesn’t mean that you could have known the same thing by just reading Keynes once more.
Third, and most surprising, is Krugman’s Luddite attack on mathematics; “economists as a group, mistook beauty, clad in impressive-looking mathematics, for truth.” Models are “gussied up with fancy equations.” I’m old enough to remember when Krugman was young, working out the interactions of game theory and increasing returns in international trade for which he won the Nobel Prize, and the old guard tut-tutted “nice recreational mathematics, but not real-world at all.” He once wrote eloquently about how only math keeps your ideas straight in economics. How quickly time passes.
Again, what is the alternative? Does Krugman really think we can make progress on his – and my – agenda for economic and financial research -- understanding frictions, imperfect markets, complex human behavior, institutional rigidities – by reverting to a literary style of exposition, and abandoning the attempt to compare theories quantitatively against data? Against the worldwide tide of quantification in all fields of human endeavor (read “Moneyball”) is there any real hope that this will work in economics?
No, the problem is that we don’t have enough math. Math in economics serves to keep the logic straight, to make sure that the “then” really does follow the “if,” which it so frequently does not if you just write prose. The challenge is how hard it is to write down explicit artificial economies with these ingredients, actually solve them, in order to see what makes them tick. Frictions are just bloody hard with the mathematical tools we have now.
The insults.
The level of personal attack in this article, and fudging of the facts to achieve it, is simply amazing.
As one little example (ok, I’m a bit sensitive), take my quotation about carpenters in Nevada. I didn’t write this. It’s a quote, taken out of context, from a bloomberg.com article, written by a reporter who I spent about 10 hours with patiently trying to explain some basics, and who also turned out only to be on a hunt for embarrassing quotes. (It’s the last time I’ll do that!) I was trying to explain how sectoral shifts contribute to unemployment. Krugman follows it by a lie -- I never asserted that “it take mass unemployment across the whole nation to get carpenters to move out of Nevada.” You can’t even dredge up a quote for that monstrosity.
What’s the point? I don’t think Paul disagrees that sectoral shifts result in some unemployment, so the quote actually makes sense as economics. The only point is to make me, personally, seem heartless -- a pure, personal, calumnious attack, having nothing to do with economics.
Bob Lucas has written extensively on Keynesian and monetarist economics, sensibly and even-handedly. Krugman chooses to quote a joke, made back in 1980 at a lunch talk to some business school alumni. Really, this is on the level of the picture of Barack Obama with Bill Ayres that Sean Hannity likes to show on Fox News.
It goes on. Krugman asserts that I and others “believe” “that an increase in government spending cannot, under any circumstances, increase employment,” or that we “argued that price fluctuations and shocks to demand actually had nothing to do with the business cycle.” These are just gross distortions, unsupported by any documentation, let alone professional writing. And Krugman knows better. All economic models are simplified to exhibit one point; we all understand the real world is more complicated; and his job is supposed to be to explain that to lay readers. It would be no different than if someone were to look up Paul’s early work which assumed away transport costs and claim “Paul Krugman believes ocean shipping is free, how stupid” in the Wall Street Journal.
The idea that any of us do what we do because we’re paid off by fancy Wall Street salaries or cushy sabbaticals at Hoover is just ridiculous. (If Krugman knew anything about hedge funds he’d know that believing in efficient markets disqualifies you for employment. Nobody wants a guy who thinks you can’t make any money trading!) Given Krugman’s speaking fees, it’s a surprising first stone for him to cast.
Apparently, salacious prose, innuendo, calumny, and selective quotation from media aren’t enough: Krugman added cartoons to try to make opponents look silly. The Lucas-Blanchard-Bernanke conspiratorial cocktail party celebrating the end of recessions is a silly fiction. So is their despondent gloom on reading “recession” in the paper. Nobody at a conference looks like Dr. Pangloss with wild hair and a suit from the 1800s. (OK, Randy Wright has the hair, but not the suit.) Keynes did not reappear at the NBER to be booed as an “outsider.” Why are you allowed to make things up in pictures that wouldn’t pass even the Times’ weak fact-checking in words?
M of all, Paul isn’t doing his job. He’s supposed to read, explain, and criticize things economists write, and real professional writing, not interviews, opeds and blog posts. At a minimum, this style leads to the unavoidable conclusion that Krugman isn’t reading real economics anymore.
How did Krugman get it so wrong?
So what is Krugman up to? Why become a denier, a skeptic, an apologist for 70 year old ideas, replete with well-known logical fallacies, a pariah? Why publish an essentially personal attack on an ever-growing enemies list that now includes practically every professional economist? Why publish an incoherent vision for the future of economics?
The only explanation that makes sense to me is that Krugman isn’t trying to be an economist, he is trying to be a partisan, political opinion writer. This is not an insult. I read George Will, Charles Krauthnammer and Frank Rich with equal pleasure even when I disagree with them. Krugman wants to be Rush Limbaugh of the Left.
Alas, to Krugman, as to far too many ex-economists in partisan debates, economics is not a quest for understanding. It is a set of debating points to argue for policies that one has adopted for partisan political purposes. “Stimulus” is just marketing to sell Congressmen and voters on a package of government spending priorities that you want for political reasons. It’s not a proposition to be explained, understood, taken seriously to its logical limits, or reflective of market failures that should be addressed directly.
Why argue for a nonsensical future for economics? Well, again, if you don’t regard economics as a science, a discipline that ought to result in quantitative matches to data, a discipline that requires crystal-clear logical connections between the “if” and the “then,” if the point of economics is merely to provide marketing and propaganda for politically-motivated policy, then his writing does make sense. It makes sense to appeal to some future economics – not yet worked out, even verbally – to disdain quantification and comparison to data, and to appeal to the authority of ancient books as interpreted you, their lone remaining apostle.
Most of all, this is the only reason I can come up with to understand why Krugman wants to write personal attacks on those who disagree with him. I like it when people disagree with me, and take time to read my work and criticize it. At worst I learn how to position it better. At best, I discover I was wrong and learn something. I send a polite thank you note.
Krugman wants people to swallow his arguments whole from his authority, without demanding logic, or evidence. Those who disagree with him, alas, are pretty smart and have pretty good arguments if you bother to read them. So, he tries to discredit them with personal attacks.
This is the political sphere, not the intellectual one. Don’t argue with them, swift-boat them. Find some embarrassing quote from an old interview. Well, good luck, Paul. Let’s just not pretend this has anything to do with economics, or actual truth about how the world works or could be made a better place.
*University of Chicago Booth School of Business. Many colleagues and friends helped, but I don’t want to name them for obvious reasons. Krugman fans: Please don’t bother emailing me to tell me what a jerk I am. I will update this occasionally, so please pass on the link rather than the document, http://faculty.chicagobooth.edu/john.cochrane/research/Papers/#news.
John H. Cochrane*
Many friends and colleagues have asked me what I think of Paul Krugman’s New York Times Magazine article, “How did Economists get it so wrong?”
Most of all, it’s sad. Imagine this weren’t economics for a moment. Imagine this were a respected scientist turned popular writer, who says, most basically, that everything everyone has done in his field since the mid 1960s is a complete waste of time. Everything that fills its academic journals, is taught in its PhD programs, presented at its conferences, summarized in its graduate textbooks, and rewarded with the accolades a profession can bestow, including multiple Nobel prizes, is totally wrong. Instead, he calls for a return to the eternal verities of a rather convoluted book written in the 1930s, as taught to our author in his undergraduate introductory courses. If a scientist, he might be a global-warming skeptic, an AIDS-HIV disbeliever, a creationist, a stalwart that maybe continents don’t move after all.
It gets worse. Krugman hints at dark conspiracies, claiming “dissenters are marginalized.” Most of the article is just a calumnious personal attack on an ever-growing enemies list, which now includes “new Keyenesians” such as Olivier Blanchard and Greg Mankiw. Rather than source professional writing, he plays gotcha with out-of-context second-hand quotes from media interviews. He makes stuff up, boldly putting words in people’s mouths that run contrary to their written opinions. Even this isn’t enough: he adds cartoons to try to make his “enemies” look silly, and puts them in false and embarrassing situations. He accuses us of adopting ideas for pay, selling out for “sabbaticals at the Hoover institution” and fat “Wall street paychecks.” It sounds a bit paranoid.
It’s annoying to the victims, but we’re big boys and girls. It’s a disservice to New York Times readers. They depend on Krugman to read real academic literature and digest it, and they get this attack instead. And it’s ineffective. Any astute reader knows that personal attacks and innuendo mean the author has run out of ideas.
That’s the biggest and saddest news of this piece: Paul Krugman has no interesting ideas whatsoever about what caused our current financial and economic problems, what policies might have prevented it, or what might help us in the future, and he has no contact with people who do. “Irrationality” and advice to spend like a drunken sailor are pretty superficial compared to all the fascinating things economists are writing about it these days.
How sad.
That’s what I think, but I don’t expect you the reader to be convinced by my opinion or my reference to professional consensus. Maybe he is right. Occasionally sciences, especially social sciences, do take a wrong turn for a decade or two. I thought Keynesian economics was such a wrong turn. So let’s take a quick look at the ideas.
Krugman’s attack has two goals. First, he thinks financial markets are “inefficient,” fundamentally due to “irrational” investors, and thus prey to excessive volatility which needs government control. Second, he likes the huge “fiscal stimulus” provided by multi-trillion dollar deficits.
Efficiency.
It’s fun to say we didn’t see the crisis coming, but the central empirical prediction of the efficient markets hypothesis is precisely that nobody can tell where markets are going – neither benevolent government bureaucrats, nor crafty hedge-fund managers, nor ivory-tower academics. This is probably the best-tested proposition in all the social sciences. Krugman knows this, so all he can do is huff and puff about his dislike for a theory whose central prediction is that nobody can be a reliable soothsayer.
Krugman writes as if the volatility of stock prices alone disproves market efficiency, and efficient marketers just ignored it all these years. This is a canard that Paul knows better than to pass on, no matter how rhetorically convenient. (I can overlook his mixing up the CAPM and Black-Scholes model, but not this.) There is nothing about “efficiency” that promises “stability.” “Stable” growth would in fact be a major violation of efficiency. Efficient markets did not need to wait for “the memory of 1929 … gradually receding,” nor did we fail to read the newspapers in 1987. Data from the great depression has been included in practically all the tests. In fact, the great “equity premium puzzle” is that if efficient, stock markets don’t seem risky enough to deter more people from investing! Gene Fama’s PhD thesis was on “fat tails” in stock returns.
It is true and very well documented that asset prices move more than reasonable expectations of future cashflows. This might be because people are prey to bursts of irrational optimism and pessimism. It might also be because people’s willingness to take on risk varies over time, and is lower in bad economic times. As Gene Fama pointed out in 1970, these are observationally equivalent explanations. Unless you are willing to elaborate your theory to the point that it can quantitatively describe how much and when risk premiums, or waves of “optimism” and “pessimism,” can vary, you know nothing. No theory is particularly good at that right now.
Crying “bubble” is empty unless you have an operational procedure for identifying bubbles, distinguishing them from rationally low risk premiums, and not crying wolf too many years in a row. Krugman rightly praises Robert Shiller for his warnings over many years that house prices might fall. But advice that we should listen to Shiller, because he got the last one right, is no more useful than previous advice from many quarters to listen to Greenspan because he got several ones right. Following the last mystic oracle until he gets one wrong, then casting him to the wolves, is not a good long-term strategy for identifying bubbles. Krugman likes Shiller because he advocates behavioral ideas, but that’s no help either. People who call themselves behavioral have just as wide a divergence of opinion as those who don’t. Are markets irrationally exuberant or irrationally depressed? It’s hard to tell.
This difficulty is no surprise. It’s the central prediction of free-market economics, as crystallized by Hayek, that no academic, bureaucrat or regulator will ever be able to fully explain market price movements. Nobody knows what “fundamental” value is. If anyone could tell what the price of tomatoes should be, let alone the price of Microsoft stock, communism would have worked.
More deeply, the economist’s job is not to “explain” market fluctuations after the fact, to give a pleasant story on the evening news about why markets went up or down. Markets up? “A wave of positive sentiment.” Markets went down? “Irrational pessimism.” ( “The risk premium must have increased” is just as empty.) Our ancestors could do that. Really, is that an improvement on “Zeus had a fight with Apollo?” Good serious behavioral economists know this, and they are circumspect in their explanatory claims so far.
But this argument takes us away from the main point. The case for free markets never was that markets are perfect. The case for free markets is that government control of markets, especially asset markets, has always been much worse.
Krugman at bottom is arguing that the government should massively intervene in financial markets, and take charge of the allocation of capital. He can’t quite come out and say this, but he does say “Keynes considered it a very bad idea to let such markets…dictate important business decisions,” and “finance economists believed that we should put the capital development of the nation in the hands of what Keynes had called a `casino.’” Well, if markets can’t be trusted to allocate capital, we don’t have to connect too many dots to imagine who Paul has in mind.
To reach this conclusion, you need evidence, experience, or any realistic hope that the alternative will be better. Remember, the SEC couldn’t even find Bernie Madoff when he was handed to them on a silver platter. Think of the great job Fannie, Freddie, and Congress did in the mortgage market. Is this system going to regulate Citigroup, guide financial markets to the right price, replace the stock market, and tell our society which new products are worth investment? As David Wessel’s excellent In Fed We Trust makes perfectly clear, government regulators failed just as abysmally as private investors and economists to see the storm coming. And not from any lack of smarts.
In fact, the behavioral view gives us a new and stronger argument against regulation and control. Regulators are just as human and irrational as market participants. If bankers are, in Krugman’s words, “idiots,” then so must be the typical treasury secretary, fed chairman, and regulatory staff. They act alone or in committees, where behavioral biases are much better documented than in market settings. They are still easily captured by industries, and face politically distorted incentives.
Careful behavioralists know this, and do not quickly run from “the market got it wrong” to “the government can put it all right.” Even my most behavioral colleagues Richard Thaler and Cass Sunstein in their book “Nudge” go only so far as a light libertarian paternalism, suggesting good default options on our 401(k) accounts. (And even here they’re not very clear on how the Federal Nudging Agency is going to steer clear of industry capture.) They don’t even think of jumping from irrational markets, which they believe in deeply, to Federal control of stock and house prices and allocation of capital.
Stimulus
Most of all, Krugman likes fiscal stimulus. In this quest, he accuses us and the rest of the economics profession of “mistaking beauty for truth.” He’s not clear on what the “beauty” is that we all fell in love with, and why one should shun it, for good reason. The first siren of beauty is simple logical consistency. Paul’s Keynesian economics requires that people make logically inconsistent plans to consume more, invest more, and pay more taxes with the same income. The second siren is plausible assumptions about how people behave. Keynesian economics requires that the government is able to systematically fool people again and again. It presumes that people don’t think about the future in making decisions today. Logical consistency and plausible foundations are indeed “beautiful” but to me they are also basic preconditions for “truth.”
In economics, stimulus spending ran aground on Robert Barro’s Ricardian equivalence theorem. This theorem says that debt-financed spending can’t have any effect because people, seeing the higher future taxes that must pay off the debt, will simply save more. They will buy the new government debt and leave all spending decisions unaltered. Is this theorem true? It’s a logical connection from a set of “if” to a set of “therefore.” Not even Paul can object to the connection.
Therefore, we have to examine the “ifs.” And those ifs are, as usual, obviously not true. For example, the theorem presumes lump-sum taxes, not proportional income taxes. Alas, when you take this into account we are all made poorer by deficit spending, so the multiplier is most likely negative. The theorem (like most Keynesian economics) ignores the composition of output; but surely spending money on roads rather than cars can affect the overall level.
Economists have spent a generation tossing and turning the Ricardian equivalence theorem, and assessing the likely effects of fiscal stimulus in its light, generalizing the “ifs” and figuring out the likely “therefores.” This is exactly the right way to do things. The impact of Ricardian equivalence is not that this simple abstract benchmark is literally true. The impact is that in its wake, if you want to understand the effects of government spending, you have to specify why it is false. Doing so does not lead you anywhere near old-fashioned Keynesian economics. It leads you to consider distorting taxes, how much people care about their children, how many people would like to borrow more to finance today’s consumption and so on. And when you find “market failures” that might justify a multiplier, optimal-policy analysis suggests fixing the market failures, not their exploitation by fiscal multiplier. Most “New Keynesian” analyses that add frictions don’t produce big multipliers.
This is how real thinking about stimulus actually proceeds. Nobody ever “asserted that an increase in government spending cannot, under any circumstances, increase employment.” This is unsupportable by any serious review of professional writings, and Krugman knows it. (My own are perfectly clear on lots of possibilities for an answer that is not zero.) But thinking through this sort of thing and explaining it is much harder than just tarring your enemies with out-of-context quotes, ethical innuendo, or silly cartoons.
In fact, I propose that Krugman himself doesn’t really believe the Keynesian logic for that stimulus. I doubt he would follow that logic to its inevitable conclusions. Stimulus must have some other attraction to him.
If you believe the Keynesian argument for stimulus, you should think Bernie Madoff is a hero. He took money from people who were saving it, and gave it to people who most assuredly were going to spend it. Each dollar so transferred, in Krugman’s world, generates an additional dollar and a half of national income. The analogy is even closer. Madoff didn’t just take money from his savers, he essentially borrowed it from them, giving them phony accounts with promises of great profits to come. This looks a lot like government debt.
If you believe the Keynesian argument for stimulus, you don’t care how the money is spent. All this puffery about “infrastructure,” monitoring, wise investment, jobs “created” and so on is pointless. Keynes thought the government should pay people to dig ditches and fill them up.
If you believe in Keynesian stimulus, you don’t even care if the government spending money is stolen. Actually, that would be better. Thieves have notoriously high propensities to consume.
The crash.
Krugman’s article is supposedly about how the crash and recession changed our thinking, and what economics has to say about it. The most amazing news in the whole article is that Paul Krugman has absolutely no idea about what caused the crash, what policies might have prevented it, and what policies we should adopt going forward. He seems completely unaware of the large body of work by economists who actually do know something about the banking and financial system, and have been thinking about it productively for a generation.
Here’s all he has to say: “Irrationality” caused markets to go up and then down. “Spending” then declined, for unclear reasons, possibly “irrational” as well. The sum total of his policy recommendations is for the Federal Government to spend like a drunken sailor after the fact.
Paul, there was a financial crisis, a classic near-run on banks. The centerpiece of our crash was not the relatively free stock or real estate markets, it was the highly regulated commercial banks. A generation of economists has thought really hard about these kinds of events. Look up Diamond, Rajan, Gorton, Kashyap, Stein, and so on. They’ve thought about why there is so much short term debt, why banks run, how deposit insurance and credit guarantees help, and how they give incentives for excessive risk taking.
If we want to think about events and policies, this seems like more than a minor detail. The hard and central policy debate over the last year was how to manage this financial crisis. Now it is how to set up the incentives of banks and other financial institutions so this mess doesn’t happen again. There’s lots of good and subtle economics here that New York Times readers might like to know about. What does Krugman have to say? Zero.
Krugman doesn’t even have anything to say about the Fed. Ben Bernanke did a lot more last year than set the funds rate to zero and then go off on vacation and wait for fiscal policy to do its magic. Leaving aside the string of bailouts, the Fed started term lending to securities dealers. Then, rather than buy treasuries in exchange for reserves, it essentially sold treasuries in exchange for private debt. Though the funds rate was near zero, the Fed noticed huge commercial paper and securitized debt spreads, and intervened in those markets. There is no “the” interest rate anymore, the Fed is attempting to manage them all. Recently the Fed has started buying massive quantities of mortgage-backed securities and long-term treasury debt.
Monetary policy now has little to do with “money” vs. “bonds” with all the latter lumped together. Monetary policy has become wide-ranging financial policy. Does any of this work? What are the dangers? Can the Fed stay independent in this new role? These are the questions of our time. What does Krugman have to say? Nothing.
Krugman is trying to say that a cabal of obvious crackpots bedazzled all of macroeconomics with the beauty of their mathematics, to the point of inducing policy paralysis. Alas, that won’t stick. The sad fact is that few in Washington pay the slightest attention to modern macroeconomic research, in particular anything with a serious intertemporal dimension. Paul’s simple Keynesianism has dominated policy analysis for decades and continues to do so. From the CEA to the Fed to the OMB and CBO, everyone just adds up consumer, investment and government “demand” to forecast output and uses simple Phillips curves to think about inflation. If a failure of ideas caused bad policy, it’s a simpleminded Keynesianism that failed.
The future of economics.
How should economics change? Krugman argues for three incompatible changes.
First, he argues for a future of economics that “recognizes flaws and frictions,” and incorporates alternative assumptions about behavior, especially towards risk-taking. To which I say, “Hello, Paul, where have you been for the last 30 years?” Macroeconomists have not spent 30 years admiring the eternal verities of Kydland and Prescott’s 1982 paper. Pretty much all we have been doing for 30 years is introducing flaws, frictions and new behaviors, especially new models of attitudes to risk, and comparing the resulting models, quantitatively, to data. The long literature on financial crises and banking which Krugman does not mention has also been doing exactly the same.
Second, Krugman argues that “a more or less Keynesian view is the only plausible game in town,” and “Keynesian economics remains the best framework we have for making sense of recessions and depressions.” One thing is pretty clear by now, that when economics incorporates flaws and frictions, the result will not be to rehabilitate an 80-year-old book. As Paul bemoans, the “new Keynesians” who did just what he asks, putting Keynes inspired price-stickiness into logically coherent models, ended up with something that looked a lot more like monetarism. (Actually, though this is the consensus, my own work finds that new-Keynesian economics ended up with something much different and more radical than monetarism.) A science that moves forward almost never ends up back where it started. Einstein revises Newton, but does not send you back to Aristotle. At best you can play the fun game of hunting for inspirational quotes, but that doesn’t mean that you could have known the same thing by just reading Keynes once more.
Third, and most surprising, is Krugman’s Luddite attack on mathematics; “economists as a group, mistook beauty, clad in impressive-looking mathematics, for truth.” Models are “gussied up with fancy equations.” I’m old enough to remember when Krugman was young, working out the interactions of game theory and increasing returns in international trade for which he won the Nobel Prize, and the old guard tut-tutted “nice recreational mathematics, but not real-world at all.” He once wrote eloquently about how only math keeps your ideas straight in economics. How quickly time passes.
Again, what is the alternative? Does Krugman really think we can make progress on his – and my – agenda for economic and financial research -- understanding frictions, imperfect markets, complex human behavior, institutional rigidities – by reverting to a literary style of exposition, and abandoning the attempt to compare theories quantitatively against data? Against the worldwide tide of quantification in all fields of human endeavor (read “Moneyball”) is there any real hope that this will work in economics?
No, the problem is that we don’t have enough math. Math in economics serves to keep the logic straight, to make sure that the “then” really does follow the “if,” which it so frequently does not if you just write prose. The challenge is how hard it is to write down explicit artificial economies with these ingredients, actually solve them, in order to see what makes them tick. Frictions are just bloody hard with the mathematical tools we have now.
The insults.
The level of personal attack in this article, and fudging of the facts to achieve it, is simply amazing.
As one little example (ok, I’m a bit sensitive), take my quotation about carpenters in Nevada. I didn’t write this. It’s a quote, taken out of context, from a bloomberg.com article, written by a reporter who I spent about 10 hours with patiently trying to explain some basics, and who also turned out only to be on a hunt for embarrassing quotes. (It’s the last time I’ll do that!) I was trying to explain how sectoral shifts contribute to unemployment. Krugman follows it by a lie -- I never asserted that “it take mass unemployment across the whole nation to get carpenters to move out of Nevada.” You can’t even dredge up a quote for that monstrosity.
What’s the point? I don’t think Paul disagrees that sectoral shifts result in some unemployment, so the quote actually makes sense as economics. The only point is to make me, personally, seem heartless -- a pure, personal, calumnious attack, having nothing to do with economics.
Bob Lucas has written extensively on Keynesian and monetarist economics, sensibly and even-handedly. Krugman chooses to quote a joke, made back in 1980 at a lunch talk to some business school alumni. Really, this is on the level of the picture of Barack Obama with Bill Ayres that Sean Hannity likes to show on Fox News.
It goes on. Krugman asserts that I and others “believe” “that an increase in government spending cannot, under any circumstances, increase employment,” or that we “argued that price fluctuations and shocks to demand actually had nothing to do with the business cycle.” These are just gross distortions, unsupported by any documentation, let alone professional writing. And Krugman knows better. All economic models are simplified to exhibit one point; we all understand the real world is more complicated; and his job is supposed to be to explain that to lay readers. It would be no different than if someone were to look up Paul’s early work which assumed away transport costs and claim “Paul Krugman believes ocean shipping is free, how stupid” in the Wall Street Journal.
The idea that any of us do what we do because we’re paid off by fancy Wall Street salaries or cushy sabbaticals at Hoover is just ridiculous. (If Krugman knew anything about hedge funds he’d know that believing in efficient markets disqualifies you for employment. Nobody wants a guy who thinks you can’t make any money trading!) Given Krugman’s speaking fees, it’s a surprising first stone for him to cast.
Apparently, salacious prose, innuendo, calumny, and selective quotation from media aren’t enough: Krugman added cartoons to try to make opponents look silly. The Lucas-Blanchard-Bernanke conspiratorial cocktail party celebrating the end of recessions is a silly fiction. So is their despondent gloom on reading “recession” in the paper. Nobody at a conference looks like Dr. Pangloss with wild hair and a suit from the 1800s. (OK, Randy Wright has the hair, but not the suit.) Keynes did not reappear at the NBER to be booed as an “outsider.” Why are you allowed to make things up in pictures that wouldn’t pass even the Times’ weak fact-checking in words?
M of all, Paul isn’t doing his job. He’s supposed to read, explain, and criticize things economists write, and real professional writing, not interviews, opeds and blog posts. At a minimum, this style leads to the unavoidable conclusion that Krugman isn’t reading real economics anymore.
How did Krugman get it so wrong?
So what is Krugman up to? Why become a denier, a skeptic, an apologist for 70 year old ideas, replete with well-known logical fallacies, a pariah? Why publish an essentially personal attack on an ever-growing enemies list that now includes practically every professional economist? Why publish an incoherent vision for the future of economics?
The only explanation that makes sense to me is that Krugman isn’t trying to be an economist, he is trying to be a partisan, political opinion writer. This is not an insult. I read George Will, Charles Krauthnammer and Frank Rich with equal pleasure even when I disagree with them. Krugman wants to be Rush Limbaugh of the Left.
Alas, to Krugman, as to far too many ex-economists in partisan debates, economics is not a quest for understanding. It is a set of debating points to argue for policies that one has adopted for partisan political purposes. “Stimulus” is just marketing to sell Congressmen and voters on a package of government spending priorities that you want for political reasons. It’s not a proposition to be explained, understood, taken seriously to its logical limits, or reflective of market failures that should be addressed directly.
Why argue for a nonsensical future for economics? Well, again, if you don’t regard economics as a science, a discipline that ought to result in quantitative matches to data, a discipline that requires crystal-clear logical connections between the “if” and the “then,” if the point of economics is merely to provide marketing and propaganda for politically-motivated policy, then his writing does make sense. It makes sense to appeal to some future economics – not yet worked out, even verbally – to disdain quantification and comparison to data, and to appeal to the authority of ancient books as interpreted you, their lone remaining apostle.
Most of all, this is the only reason I can come up with to understand why Krugman wants to write personal attacks on those who disagree with him. I like it when people disagree with me, and take time to read my work and criticize it. At worst I learn how to position it better. At best, I discover I was wrong and learn something. I send a polite thank you note.
Krugman wants people to swallow his arguments whole from his authority, without demanding logic, or evidence. Those who disagree with him, alas, are pretty smart and have pretty good arguments if you bother to read them. So, he tries to discredit them with personal attacks.
This is the political sphere, not the intellectual one. Don’t argue with them, swift-boat them. Find some embarrassing quote from an old interview. Well, good luck, Paul. Let’s just not pretend this has anything to do with economics, or actual truth about how the world works or could be made a better place.
*University of Chicago Booth School of Business. Many colleagues and friends helped, but I don’t want to name them for obvious reasons. Krugman fans: Please don’t bother emailing me to tell me what a jerk I am. I will update this occasionally, so please pass on the link rather than the document, http://faculty.chicagobooth.edu/john.cochrane/research/Papers/#news.
Tuesday, August 25, 2009
Are Macroeconomic Models Useful?
Economist's View
There has been no shortage of effort devoted to predicting earthquakes, yet we still can't see them coming far enough in advance to move people to safety. When a big earthquake hits, it is a surprise. We may be able to look at the data after the fact and see that certain stresses were building, so it looks like we should have known an earthquake was going to occur at any moment, but these sorts of retrospective analyses have not allowed us to predict the next one. The exact timing and location is always a surprise.Does that mean that science has failed? Should we criticize the models as useless?
No. There are two uses of models. One is to understand how the world works, another is to make predictions about the future. We may never be able to predict earthquakes far enough in advance and with enough specificity to allow us time to move to safety before they occur, but that doesn't prevent us from understanding the science underlying earthquakes. Perhaps as our understanding increases prediction will be possible, and for that reason scientists shouldn't give up trying to improve their models, but for now we simply cannot predict the arrival of earthquakes.
However, even though earthquakes cannot be predicted, at least not yet, it would be wrong to conclude that science has nothing to offer. First, understanding how earthquakes occur can help us design buildings and make other changes to limit the damage even if we don't know exactly when an earthquake will occur. Second, if an earthquake happens and, despite our best efforts to insulate against it there are still substantial consequences, science can help us to offset and limit the damage. To name just one example, the science surrounding disease transmission helps use to avoid contaminated water supplies after a disaster, something that often compounds tragedy when this science is not available. But there are lots of other things we can do as well, including using the models to determine where help is most needed.
So even if we cannot predict earthquakes, and we can't, the models are still useful for understanding how earthquakes happen. This understanding is valuable because it helps us to prepare for disasters in advance, and to determine policies that will minimize their impact after they happen.
All of this can be applied to macroeconomics. Whether or not we should have predicted the financial earthquake is a question that has been debated extensively, so I am going to set that aside. One side says financial market price changes, like earthquakes, are inherently unpredictable -- we will never predict them no matter how good our models get (the efficient markets types). The other side says the stresses that were building were obvious. Like the stresses that build when tectonic plates moving in opposite directions rub against each other, it was only a question of when, not if. (But even when increasing stress between two plates is observable, scientists cannot tell you for sure if a series of small earthquakes will relieve the stress and do little harm, or if there will be one big adjustment that relieves the stress all at once. With respect to the financial crisis, economists expected lots of little, small harm causing adjustments, instead we got the "big one," and the "buildings and other structures" we thought could withstand the shock all came crumbling down. On prediction in economics, perhaps someday improved models will allow us to do better than we have so far at predicting the exact timing of crises, and I think that earthquakes provide some guidance here. You have to ask first if stress is building in a particular sector, and then ask if action needs to be taken because the stress has reached dangerous levels, levels that might result in a big crash rather than a series of small stress relieving adjustments. I don't think our models are very good at detecting accumulating stress, in large part because when we are not at the long-run equilibrium, we model the short-run as though every market clears at every point in time. This means that there are no stresses continuously building in these models, the adjustments always relieve the stress and move us back toward long-run equilibrium. We have to do a better job of allowing for the build up of stress within our models, and then using these models to guide the measurement and monitoring of "stress levels" in particular markets, particularly asset markets, so we can take action when the levels are too high.)
Whether the financial crisis should have been predicted or not, the fact that it wasn't predicted does not mean that macroeconomic models are useless any more than the failure to predict earthquakes implies that earthquake science is useless. As with earthquakes, even when prediction is not possible (or missed), the models can still help us to understand how these shocks occur. That understanding is useful for getting ready for the next shock, or even preventing it, and for minimizing the consequences of shocks that do occur.
But we have done much better at dealing with the consequences of unexpected shocks ex-post than we have at getting ready for these a priori. Our equivalent of getting buildings ready for an earthquake before it happens is to use changes in institutions and regulations to insulate the financial sector and the larger economy from the negative consequences of financial and other shocks. Here I think economists made mistakes - our "buildings" were not strong enough to withstand the earthquake that hit. We could argue that the shock was so big that no amount of reasonable advance preparation would have stopped the "building" from collapsing, but I think it's more the case that enough time has passed since the last big financial earthquake that we forgot what we needed to do. We allowed new buildings to be constructed without the proper safeguards.
However, that doesn't mean the models themselves were useless. The models were there and could have provided guidance, but the implied "building codes" were ignored. Greenspan and others assumed no private builder would ever construct a building that couldn't withstand an earthquake, the market would force them to take this into consideration. But they were wrong about that, and even Greenspan now admits that government building codes are necessary. It wasn't the models, it was how they were used (or rather not used) that prevented us from putting safeguards into place.
We haven't failed at this entirely though. For example, we have had some success at putting safeguards into place before shocks occur, automatic stabilizers have done a lot to insulate against the negative consequences of the recession (though they could have been larger to stop the building from swaying as much as it has). So it's not proper to say that our models have not helped us to prepare in advance at all, the insulation social insurance programs provide is extremely important to recognize. But it is the case that we could have and should have done better at preparing before the shock hit.
I'd argue that our most successful use of models has been in cleaning up after shocks rather than predicting, preventing, or insulating against them through pre-crisis preparation. When despite our best effort to prevent it or to minimize its impact a priori, we get a recession anyway, we can use our models as a guide to monetary, fiscal, and other policies that help to reduce the consequences of the shock (this is the equivalent of, after a disaster hits, making sure that the water is safe to drink, people have food to eat, there is a plan for rebuilding quickly and efficiently, etc.). As noted above, we haven't done a very good job at predicting big crises, and we could have done a much better job at implementing regulatory and institutional changes that prevent or limit the impact of shocks. But we do a pretty good job of stepping in with policy actions that minimize the impact of shocks after they occur. This recession was bad, but it wasn't another Great Depression like it might have been without policy intervention.
Whether or not we will ever be able to predict recessions reliably, it's important to recognize that our models still provide considerable guidance for actions we can take before and after large shocks that minimize their impact and maybe even prevent them altogether (though we will have to do a better job of listening to what the models have to say). Prediction is important, but it's not the only use of models.
Monday, March 30, 2009
Did the Fed Cause the Housing Bubble? A WSJ Symposium
Don't Blame Greenspan
By David Henderson
It's become conventional wisdom that Alan Greenspan's Federal Reserve was responsible for the housing crisis. Virtually every commentator who blames Mr. Greenspan points to the low interest rates during his last few years at the Fed.
The link seems obvious. Everyone knows that the Fed can drive interest rates lower by pumping more money into the economy, right? Well, yes. But it doesn't follow that that's why interest rates were so low in the early 2000s. Other factors affect interest rates too. In particular, a sudden increase in savings will drive down interest rates. And such a shift did occur. As Mr. Greenspan pointed out on this page on March 11, there was a surge in savings from other countries. Although he names only China, some of the Middle Eastern oil-producing countries were also responsible for much of this new saving. Shift the supply curve to the right and, wonder of wonders, the price falls. In this case, the price of saving and lending is the interest rate.
But how do we know that it was an increase in saving, not an increase in the money supply, that caused interest rates to fall? Look at the money supply.
Since 2001, the annual year-to-year growth rate of MZM (money of zero maturity, which is M2 minus small time deposits plus institutional money market shares) fell from over 20% to nearly 0% by 2006. During that time, M2 (which is M1 plus time deposits) growth fell from over 10% to around 2%, and M1 (which is currency plus demand deposits) growth fell from over 10% to negative rates.
The annual growth rate of the monetary base, the magnitude over which the Fed has the most control, fell from 10% in 2001 to below 5% in 2006. Moreover, nearly all of the growth in the monetary base went into currency, an increasing proportion of which is held abroad.
Moreover, if the Fed was the culprit, why was the housing bubble world-wide? Do Mr. Greenspan's critics seriously contend that the Fed was responsible for high housing prices in, say, Spain?
This is not to say that the Greenspan Fed was blameless. Particularly disturbing is the way the lender-of-last-resort function has increased moral hazard, a trend to which Mr. Greenspan contributed and which current Fed Chairman Ben Bernanke has put on steroids.
But to the extent that the federal government is to blame, the main fed culprits are the beefed up Community Reinvestment Act and the run-amok Fannie Mae and Freddie Mac. All played a key role in loosening lending standards.
I'm not claiming that we should have a Federal Reserve. We simply can't depend on getting another good chairman like Mr. Greenspan, and are more likely to get another Arthur Burns or Ben Bernanke. Serious work by economists Lawrence H. White of the University of Missouri, St. Louis, and George Selgin of West Virginia University makes a persuasive case that abolishing the Fed and deregulating money would improve the macroeconomy. I'm making a more modest claim: Mr. Greenspan was not to blame for the housing bubble.
Mr. Henderson is a research fellow with the Hoover Institution, an economics professor at the Naval Postgraduate School, and editor of "The Concise Encyclopedia of Economics" (Liberty Fund, 2008).
What Savings Glut?
By Gerald P. O'Driscoll Jr.
Alan Greenspan responded to his critics on these pages on March 11. He singled out an op-ed by John Taylor a month earlier, "How Government Created the Financial Crisis" (Feb. 9), for special criticism. Mr. Greenspan's argument defending his policy is two-fold: (1) the Fed controls overnight interest rates, but not "long-term interest rates and the home-mortgage rates driven by them"; and (2) a global excess of savings was "the presumptive cause of the world-wide decline in long-term rates."
Neither argument stands up to scrutiny. First, Mr. Greenspan writes as if mortgages were of the 30-year variety, financed by 30-year money. Would that it were so! We would not be in the present mess. But the post-2002 period was characterized by one-year adjustable-rate mortgages (ARMs), teaser rates that reset in two or three years, etc. Five-year ARMs became "long-term" money.
The Fed only determines the overnight, federal-funds rate, but movements in that rate substantially influence the rates on such mortgages. Additionally, maturity-mismatches abounded and were the source of much of the current financial stress. Short-dated commercial paper funded investment banks and other entities dealing in mortgage-backed securities.
Second, Mr. Greenspan offers conjecture, not evidence, for his claim of a global savings excess. Mr. Taylor has cited evidence from the IMF to the contrary, however. Global savings and investment as a share of world GDP have been declining since the 1970s. The data is in Mr. Taylor's new book, "Getting Off Track."
The former Fed chairman also cautions against excessive regulation as a policy response to the crisis. On this point I concur. He does not directly address, however, the Fed's policy response. From the beginning, the Fed diagnosed the problem as lack of liquidity and employed every means at its disposal to supply liquidity to credit markets. It has been to little avail and, in the process, the Fed has loaded up its balance sheet with dubious assets.
The credit crunch continues because many banks are capital-impaired, not illiquid. Treasury's policy shifts and inconsistencies under both administrations have sidelined potential private capital. Treasury became the capital provider of last resort. It was late to recognize the hole in banks' balance sheets and consistently underestimated its size. The need to provide second- and even third-round capital injections proves that.
In summary, Fed policy did help cause the bubble. Subsequent policy responses by that institution have suffered from sins of commission and omission. As Mr. Taylor argued, the government (including the Fed) caused, prolonged, and worsened the crisis. It continues doing so.
Mr. O'Driscoll is a senior fellow at the Cato Institute. He was formerly a vice president at the Federal Reserve Bank of Dallas.
Low Rates Led to ARMs
By Todd J. Zywicki
Alan Greenspan's argument that the Federal Reserve's policies on short-term interest rates had no impact on long-term mortgage interest rates overlooks the way in which its policies changed consumer behavior.
A simple yet powerful pattern emerges from survey data of the past 25 years collected by HSH Associates (the financial publishers): The spread between fixed-rate mortgages (FRMs) and ARMs typically hovers between 100 and 150 basis points, representing the premium that a borrower has to pay to induce the lender to bear the risk of interest-rate fluctuations. At times, however, the spread between FRMs and ARMs breaks out of this band and becomes either larger or smaller than average, leading marginal consumers to prefer one to the other. Sometimes the adjustment in the market share of ARMs lags behind changes in the size of the spread, but over time when the spread widens, the percentage of ARMs increases and vice-versa.
In 1987, before subprime lending was even a gleam in Angelo Mozilo's eye, the spread rose to 300 basis points and the share of ARMs eventually rose to almost 70%, according to the Federal Finance Housing Board. When the spread shrunk to near 100 basis points in the late-1990s, the percentage of ARMs fell into the single digits. Other periods of time show similar dynamics.
In the latest cycle the spread rose from under 50 basis points at the end of 2000 to 230 basis points in mid-2004 and the percentage of ARMs rose from 10% to 40%. The Fed's subsequent increases on short-term rates caused short- and long-term rates to converge, squeezing the spread to about 50 points by 2007 and reducing ARMs to less than 10% of the market.
Record-low ARM interest rates kept housing generally affordable even as buyers could stretch to pay higher prices. Low short-term interest rates, combined with tax and other policies, also drew speculative, short-term home-flippers into certain markets. As the Fed increased short-term rates in 2005-07, interest rate resets raised monthly payments, triggering the initial round of defaults and falling home prices. Foreclosure rates initially soared on both prime and subprime ARMS much more than for FRMs.
Why did the ARM substitution result in a wave of foreclosures this time, unlike prior times? During previous times with high percentages of ARMs, the dip in short-term interest rates was a leading indicator of an eventual decline in long-term rates, reflecting the general downward trend in rates of the past 25 years. By contrast, during this housing bubble the interest rate on ARMs were artificially low and eventually rose back to the level of FRMs. There were other factors that exacerbated the problem -- most notably increased risk-layering and a decline in underwriting standards -- but the Fed's artificial lowering of short-term interest rates and the resulting substitution by consumers to ARMs triggered the bubble and subsequent crisis.
Mr. Zywicki is a professor of law at George Mason University School of Law and a senior scholar at the university's Mercatus Center. He is writing a book on consumer bankruptcy and consumer credit.
The Fed Provided the Fuel
By David Malpass
The blame for the current crisis extends well beyond the Fed -- to banks, regulators, bond raters, mortgage fraud, the Bush administration's weak-dollar policy and Lehman bankruptcy decisions, and Congress's reckless housing policies through Fannie Mae and Freddie Mac and the Community Reinvestment Act.
But the Fed provided the key fuel with its 1% interest rate choice in 2003 and 2004 and "measured" (meaning inadequate) rate hikes in 2004-2006. It ignored inflationary dollar weakness, higher interest rate choices abroad, the Taylor Rule, and the booming performance of the U.S. and global economies.
Even by the Fed's own backward-looking inflation metrics, the core consumption deflator exceeded the Fed's 2% limit for 18 quarters in a row beginning with the second quarter of 2004, while 12-month Consumer Price Index (CPI) inflation hit 4.7% in September 2005 and 5.4% in July 2008. This despite the Fed's constant assurances that inflation would moderate (unlikely given the crashing dollar.)
Despite its role as regulator and rate-setter, the Fed claimed that it could not identify asset bubbles until they popped (see my rebuttal on this page "The Fed's Moment of Weakness," Sept. 25, 2002). It is clear that the Fed's interest rate polices cause wide swings in the value of the dollar and huge momentum-based capital flows. These bring predictable -- and avoidable -- deflations, inflations and asset bubbles.
Beginning in 2003, the Fed filled the liquidity punch bowl. Low rates and the weakening dollar created a monumental carry trade (borrow dollars, buy anything). This transmitted the Fed's monetary excess abroad and into commodities. As the punch bowl overflowed, even global bonds bubbled (prices rose, yields fell), contributing to the global housing boom. Alan Greenspan singled out this correlation in his March 11 op-ed on this page, "The Fed Didn't Cause the Housing Bubble."
Given this power, the Fed should itself stop the current deflation and the economic freefall. It has to add enough liquidity to offset frozen credit markets, the collapse in the velocity of money, and bank deleveraging (which has reversed the normal money multiplier.)
The Fed was on the right track in late November when it committed to purchasing $600 billion in longer-term, government-guaranteed securities. Equities rose globally, and some credit markets thawed, including a decline in mortgage rates and corporate bond spreads. However, the Fed reversed course in January, delaying its asset purchases and shrinking its balance sheet. Growth in the money supply stopped. Since then, the Fed increased the amount of assets it intends to purchase, but lengthened the time period rather than accelerating the pace of purchases.
Given the magnitude of the crisis and the stakes, the Fed should be buying safe assets fast, not parceling out a few billion. Confidence and money velocity would also increase if the Fed committed itself to dollar stability, not instability, to avoid causing future inflations and deflations.
Mr. Malpass is president of Encima Global LLC.
Loose Money and the Derivative Bubble
By Judy Shelton
The Fed owns this crisis. The buck stops there -- but it didn't.
Too many dollars were churned out, year after year, for the economy to absorb; more credit was created than could be fruitfully utilized. Some of it went into subprime mortgages, yes, but the monetary excess that fueled the most threatening "systemic risk" bubble went into highly speculative financial derivatives that rode atop packaged, mortgage-backed securities until they dropped from exhaustion.
The whole point of having a central bank is to calibrate the money supply to the genuine needs of an economy -- to purchase goods and services, to fund productive investment -- with the aim of achieving maximum sustainable long-term growth. Since price stability is a key factor toward that end, central bankers attempt to finesse the amount of money and credit in the system; if interest rates are kept too low too long, it causes an unwarranted expansion of credit. As the money supply increases relative to real economic production, the spillage of excess purchasing power results in higher prices for goods and services.
But not always. Sometimes the monetary excess finds its way into a narrow sector of the economy -- such as real estate, or equities, or rare art. This time it was the financial derivatives market.
In the last six years, according to the Bank for International Settlements, the derivatives market exploded as a global haven for speculative investment, its aggregate notional value rising more than fivefold to $684 trillion in 2008 from $127 trillion in 2002. Financial obligations amounting to 12 times the value of the entire world's gross domestic product were written and traded and retraded among financial institutions -- playing off every instance of market turbulence, every gyration in exchange rates, every nuanced statement uttered by a central banker in Washington or Frankfurt -- like so many tulip contracts.
The sheer enormity of this speculative bubble, let alone the speed at which it inflated, testifies to inordinately loose monetary policy from the Fed, keeper of the world's predominant currency. The fact that Fannie Mae and Freddie Mac provided the "underlying security" for many of the derivative contracts merely compounds the error of government intervention in the private sector. Politicians altered normal credit risk parameters, while the Fed distorted housing prices through perpetual inflation.
At this point, dickering over whether Alan Greenspan should have formulated monetary policy in strict accordance with an econometrically determined "rule," or whether the Fed even has the power to influence long-term rates, raises a more fundamental question: Why do we need a central bank?
"There are numbers of us, myself included, who strongly believe that we did very well in the 1870 to 1914 period with an international gold standard." That was Mr. Greenspan, speaking 17 months ago on the Fox Business Network.
In the rules-versus-discretion debate over how best to achieve sound money, that is the ultimate answer.
Ms. Shelton, an economist, is author of "Money Meltdown" (Free Press, 1994).
To Change Policy, Change The Law
By Vincent Reinhart
Anyone seeking an application of the principle that fame is fleeting need look no further than the assessment of Federal Reserve policy from 2002 to 2005.
At the beginning, capital spending was anemic, and considerable wealth had been destroyed by the equity crash. The recovery from the 1990-91 recession was "jobless," and the current one was following the same script. Moreover, inflation was so distinctly pointed down that deflation seemed a palpable threat.
Keeping the federal-funds rate low for a long time was viewed as appropriately balancing the risks to the Fed's dual objectives of maximum employment and price stability. Indeed, the Fed was seen as extending the stable economic performance since 1983 that had been dubbed the "Great Moderation."
Over the period 2002-2005, the federal-funds rate ran below the recommendation of the policy rule made famous by Stanford Professor John Taylor. No doubt, the Taylor Rule provides important guidance on how that rate should change in response to changes in the two mandated goals of policy. First, it should move up or down by more than any change in inflation. Second, the Fed should respond to changes in resource slack. That is, caring about unemployment is not a sign of weakness in a central banker but rather that of strength in better achieving good results.
The Taylor Rule is less helpful to practitioners of policy in anchoring the level of the federal-funds rate. The rule is fit to experience based on a notion of the rate that should prevail if inflation were at its goal and resources fully employed, which is known as the equilibrium funds rate. That is an important technicality. Using a faulty estimate of the equilibrium funds rate is like flying a plane that is otherwise perfect except for an unreliable altimeter. The exception looms large when flying over a mountainous region.
From 2002 to 2005, the economic landscape appeared especially changeable, with the contours shaped by lower wealth, lingering job losses, and looming disinflation. To Fed officials at the time, this indicated that the equilibrium funds rate was unusually low. Simply, the only way to provide lift to an economy in which resource use was slack and inflation pointed down was to keep policy accommodative relative to longer-term standards.
That was then. Now, policy during the period is seen as fueling a housing bubble.
The Fed is guilty as charged in setting policy to achieve the goals mandated in the law. Fed policy makers cannot be held responsible for the fuel to speculative fires provided by foreign saving and the thin compensation for risk that satisfied global investors. Nor can the chain of subsequent mistakes that drove a downturn into a debacle be laid at the feet of the Federal Open Market Committee of 2002 to 2005. If the results seem less than desirable in retrospect, change the law those policy makers were following, but do not blame them for following prevailing law.
Mr. Reinhart is a resident scholar at the American Enterprise Institute. From August 2001 to June 2007, he was the secretary and economist of the Federal Open Market Committee.
By David Henderson
It's become conventional wisdom that Alan Greenspan's Federal Reserve was responsible for the housing crisis. Virtually every commentator who blames Mr. Greenspan points to the low interest rates during his last few years at the Fed.
The link seems obvious. Everyone knows that the Fed can drive interest rates lower by pumping more money into the economy, right? Well, yes. But it doesn't follow that that's why interest rates were so low in the early 2000s. Other factors affect interest rates too. In particular, a sudden increase in savings will drive down interest rates. And such a shift did occur. As Mr. Greenspan pointed out on this page on March 11, there was a surge in savings from other countries. Although he names only China, some of the Middle Eastern oil-producing countries were also responsible for much of this new saving. Shift the supply curve to the right and, wonder of wonders, the price falls. In this case, the price of saving and lending is the interest rate.
But how do we know that it was an increase in saving, not an increase in the money supply, that caused interest rates to fall? Look at the money supply.
Since 2001, the annual year-to-year growth rate of MZM (money of zero maturity, which is M2 minus small time deposits plus institutional money market shares) fell from over 20% to nearly 0% by 2006. During that time, M2 (which is M1 plus time deposits) growth fell from over 10% to around 2%, and M1 (which is currency plus demand deposits) growth fell from over 10% to negative rates.
The annual growth rate of the monetary base, the magnitude over which the Fed has the most control, fell from 10% in 2001 to below 5% in 2006. Moreover, nearly all of the growth in the monetary base went into currency, an increasing proportion of which is held abroad.
Moreover, if the Fed was the culprit, why was the housing bubble world-wide? Do Mr. Greenspan's critics seriously contend that the Fed was responsible for high housing prices in, say, Spain?
This is not to say that the Greenspan Fed was blameless. Particularly disturbing is the way the lender-of-last-resort function has increased moral hazard, a trend to which Mr. Greenspan contributed and which current Fed Chairman Ben Bernanke has put on steroids.
But to the extent that the federal government is to blame, the main fed culprits are the beefed up Community Reinvestment Act and the run-amok Fannie Mae and Freddie Mac. All played a key role in loosening lending standards.
I'm not claiming that we should have a Federal Reserve. We simply can't depend on getting another good chairman like Mr. Greenspan, and are more likely to get another Arthur Burns or Ben Bernanke. Serious work by economists Lawrence H. White of the University of Missouri, St. Louis, and George Selgin of West Virginia University makes a persuasive case that abolishing the Fed and deregulating money would improve the macroeconomy. I'm making a more modest claim: Mr. Greenspan was not to blame for the housing bubble.
Mr. Henderson is a research fellow with the Hoover Institution, an economics professor at the Naval Postgraduate School, and editor of "The Concise Encyclopedia of Economics" (Liberty Fund, 2008).
What Savings Glut?
By Gerald P. O'Driscoll Jr.
Alan Greenspan responded to his critics on these pages on March 11. He singled out an op-ed by John Taylor a month earlier, "How Government Created the Financial Crisis" (Feb. 9), for special criticism. Mr. Greenspan's argument defending his policy is two-fold: (1) the Fed controls overnight interest rates, but not "long-term interest rates and the home-mortgage rates driven by them"; and (2) a global excess of savings was "the presumptive cause of the world-wide decline in long-term rates."
Neither argument stands up to scrutiny. First, Mr. Greenspan writes as if mortgages were of the 30-year variety, financed by 30-year money. Would that it were so! We would not be in the present mess. But the post-2002 period was characterized by one-year adjustable-rate mortgages (ARMs), teaser rates that reset in two or three years, etc. Five-year ARMs became "long-term" money.
The Fed only determines the overnight, federal-funds rate, but movements in that rate substantially influence the rates on such mortgages. Additionally, maturity-mismatches abounded and were the source of much of the current financial stress. Short-dated commercial paper funded investment banks and other entities dealing in mortgage-backed securities.
Second, Mr. Greenspan offers conjecture, not evidence, for his claim of a global savings excess. Mr. Taylor has cited evidence from the IMF to the contrary, however. Global savings and investment as a share of world GDP have been declining since the 1970s. The data is in Mr. Taylor's new book, "Getting Off Track."
The former Fed chairman also cautions against excessive regulation as a policy response to the crisis. On this point I concur. He does not directly address, however, the Fed's policy response. From the beginning, the Fed diagnosed the problem as lack of liquidity and employed every means at its disposal to supply liquidity to credit markets. It has been to little avail and, in the process, the Fed has loaded up its balance sheet with dubious assets.
The credit crunch continues because many banks are capital-impaired, not illiquid. Treasury's policy shifts and inconsistencies under both administrations have sidelined potential private capital. Treasury became the capital provider of last resort. It was late to recognize the hole in banks' balance sheets and consistently underestimated its size. The need to provide second- and even third-round capital injections proves that.
In summary, Fed policy did help cause the bubble. Subsequent policy responses by that institution have suffered from sins of commission and omission. As Mr. Taylor argued, the government (including the Fed) caused, prolonged, and worsened the crisis. It continues doing so.
Mr. O'Driscoll is a senior fellow at the Cato Institute. He was formerly a vice president at the Federal Reserve Bank of Dallas.
Low Rates Led to ARMs
By Todd J. Zywicki
Alan Greenspan's argument that the Federal Reserve's policies on short-term interest rates had no impact on long-term mortgage interest rates overlooks the way in which its policies changed consumer behavior.
A simple yet powerful pattern emerges from survey data of the past 25 years collected by HSH Associates (the financial publishers): The spread between fixed-rate mortgages (FRMs) and ARMs typically hovers between 100 and 150 basis points, representing the premium that a borrower has to pay to induce the lender to bear the risk of interest-rate fluctuations. At times, however, the spread between FRMs and ARMs breaks out of this band and becomes either larger or smaller than average, leading marginal consumers to prefer one to the other. Sometimes the adjustment in the market share of ARMs lags behind changes in the size of the spread, but over time when the spread widens, the percentage of ARMs increases and vice-versa.
In 1987, before subprime lending was even a gleam in Angelo Mozilo's eye, the spread rose to 300 basis points and the share of ARMs eventually rose to almost 70%, according to the Federal Finance Housing Board. When the spread shrunk to near 100 basis points in the late-1990s, the percentage of ARMs fell into the single digits. Other periods of time show similar dynamics.
In the latest cycle the spread rose from under 50 basis points at the end of 2000 to 230 basis points in mid-2004 and the percentage of ARMs rose from 10% to 40%. The Fed's subsequent increases on short-term rates caused short- and long-term rates to converge, squeezing the spread to about 50 points by 2007 and reducing ARMs to less than 10% of the market.
Record-low ARM interest rates kept housing generally affordable even as buyers could stretch to pay higher prices. Low short-term interest rates, combined with tax and other policies, also drew speculative, short-term home-flippers into certain markets. As the Fed increased short-term rates in 2005-07, interest rate resets raised monthly payments, triggering the initial round of defaults and falling home prices. Foreclosure rates initially soared on both prime and subprime ARMS much more than for FRMs.
Why did the ARM substitution result in a wave of foreclosures this time, unlike prior times? During previous times with high percentages of ARMs, the dip in short-term interest rates was a leading indicator of an eventual decline in long-term rates, reflecting the general downward trend in rates of the past 25 years. By contrast, during this housing bubble the interest rate on ARMs were artificially low and eventually rose back to the level of FRMs. There were other factors that exacerbated the problem -- most notably increased risk-layering and a decline in underwriting standards -- but the Fed's artificial lowering of short-term interest rates and the resulting substitution by consumers to ARMs triggered the bubble and subsequent crisis.
Mr. Zywicki is a professor of law at George Mason University School of Law and a senior scholar at the university's Mercatus Center. He is writing a book on consumer bankruptcy and consumer credit.
The Fed Provided the Fuel
By David Malpass
The blame for the current crisis extends well beyond the Fed -- to banks, regulators, bond raters, mortgage fraud, the Bush administration's weak-dollar policy and Lehman bankruptcy decisions, and Congress's reckless housing policies through Fannie Mae and Freddie Mac and the Community Reinvestment Act.
But the Fed provided the key fuel with its 1% interest rate choice in 2003 and 2004 and "measured" (meaning inadequate) rate hikes in 2004-2006. It ignored inflationary dollar weakness, higher interest rate choices abroad, the Taylor Rule, and the booming performance of the U.S. and global economies.
Even by the Fed's own backward-looking inflation metrics, the core consumption deflator exceeded the Fed's 2% limit for 18 quarters in a row beginning with the second quarter of 2004, while 12-month Consumer Price Index (CPI) inflation hit 4.7% in September 2005 and 5.4% in July 2008. This despite the Fed's constant assurances that inflation would moderate (unlikely given the crashing dollar.)
Despite its role as regulator and rate-setter, the Fed claimed that it could not identify asset bubbles until they popped (see my rebuttal on this page "The Fed's Moment of Weakness," Sept. 25, 2002). It is clear that the Fed's interest rate polices cause wide swings in the value of the dollar and huge momentum-based capital flows. These bring predictable -- and avoidable -- deflations, inflations and asset bubbles.
Beginning in 2003, the Fed filled the liquidity punch bowl. Low rates and the weakening dollar created a monumental carry trade (borrow dollars, buy anything). This transmitted the Fed's monetary excess abroad and into commodities. As the punch bowl overflowed, even global bonds bubbled (prices rose, yields fell), contributing to the global housing boom. Alan Greenspan singled out this correlation in his March 11 op-ed on this page, "The Fed Didn't Cause the Housing Bubble."
Given this power, the Fed should itself stop the current deflation and the economic freefall. It has to add enough liquidity to offset frozen credit markets, the collapse in the velocity of money, and bank deleveraging (which has reversed the normal money multiplier.)
The Fed was on the right track in late November when it committed to purchasing $600 billion in longer-term, government-guaranteed securities. Equities rose globally, and some credit markets thawed, including a decline in mortgage rates and corporate bond spreads. However, the Fed reversed course in January, delaying its asset purchases and shrinking its balance sheet. Growth in the money supply stopped. Since then, the Fed increased the amount of assets it intends to purchase, but lengthened the time period rather than accelerating the pace of purchases.
Given the magnitude of the crisis and the stakes, the Fed should be buying safe assets fast, not parceling out a few billion. Confidence and money velocity would also increase if the Fed committed itself to dollar stability, not instability, to avoid causing future inflations and deflations.
Mr. Malpass is president of Encima Global LLC.
Loose Money and the Derivative Bubble
By Judy Shelton
The Fed owns this crisis. The buck stops there -- but it didn't.
Too many dollars were churned out, year after year, for the economy to absorb; more credit was created than could be fruitfully utilized. Some of it went into subprime mortgages, yes, but the monetary excess that fueled the most threatening "systemic risk" bubble went into highly speculative financial derivatives that rode atop packaged, mortgage-backed securities until they dropped from exhaustion.
The whole point of having a central bank is to calibrate the money supply to the genuine needs of an economy -- to purchase goods and services, to fund productive investment -- with the aim of achieving maximum sustainable long-term growth. Since price stability is a key factor toward that end, central bankers attempt to finesse the amount of money and credit in the system; if interest rates are kept too low too long, it causes an unwarranted expansion of credit. As the money supply increases relative to real economic production, the spillage of excess purchasing power results in higher prices for goods and services.
But not always. Sometimes the monetary excess finds its way into a narrow sector of the economy -- such as real estate, or equities, or rare art. This time it was the financial derivatives market.
In the last six years, according to the Bank for International Settlements, the derivatives market exploded as a global haven for speculative investment, its aggregate notional value rising more than fivefold to $684 trillion in 2008 from $127 trillion in 2002. Financial obligations amounting to 12 times the value of the entire world's gross domestic product were written and traded and retraded among financial institutions -- playing off every instance of market turbulence, every gyration in exchange rates, every nuanced statement uttered by a central banker in Washington or Frankfurt -- like so many tulip contracts.
The sheer enormity of this speculative bubble, let alone the speed at which it inflated, testifies to inordinately loose monetary policy from the Fed, keeper of the world's predominant currency. The fact that Fannie Mae and Freddie Mac provided the "underlying security" for many of the derivative contracts merely compounds the error of government intervention in the private sector. Politicians altered normal credit risk parameters, while the Fed distorted housing prices through perpetual inflation.
At this point, dickering over whether Alan Greenspan should have formulated monetary policy in strict accordance with an econometrically determined "rule," or whether the Fed even has the power to influence long-term rates, raises a more fundamental question: Why do we need a central bank?
"There are numbers of us, myself included, who strongly believe that we did very well in the 1870 to 1914 period with an international gold standard." That was Mr. Greenspan, speaking 17 months ago on the Fox Business Network.
In the rules-versus-discretion debate over how best to achieve sound money, that is the ultimate answer.
Ms. Shelton, an economist, is author of "Money Meltdown" (Free Press, 1994).
To Change Policy, Change The Law
By Vincent Reinhart
Anyone seeking an application of the principle that fame is fleeting need look no further than the assessment of Federal Reserve policy from 2002 to 2005.
At the beginning, capital spending was anemic, and considerable wealth had been destroyed by the equity crash. The recovery from the 1990-91 recession was "jobless," and the current one was following the same script. Moreover, inflation was so distinctly pointed down that deflation seemed a palpable threat.
Keeping the federal-funds rate low for a long time was viewed as appropriately balancing the risks to the Fed's dual objectives of maximum employment and price stability. Indeed, the Fed was seen as extending the stable economic performance since 1983 that had been dubbed the "Great Moderation."
Over the period 2002-2005, the federal-funds rate ran below the recommendation of the policy rule made famous by Stanford Professor John Taylor. No doubt, the Taylor Rule provides important guidance on how that rate should change in response to changes in the two mandated goals of policy. First, it should move up or down by more than any change in inflation. Second, the Fed should respond to changes in resource slack. That is, caring about unemployment is not a sign of weakness in a central banker but rather that of strength in better achieving good results.
The Taylor Rule is less helpful to practitioners of policy in anchoring the level of the federal-funds rate. The rule is fit to experience based on a notion of the rate that should prevail if inflation were at its goal and resources fully employed, which is known as the equilibrium funds rate. That is an important technicality. Using a faulty estimate of the equilibrium funds rate is like flying a plane that is otherwise perfect except for an unreliable altimeter. The exception looms large when flying over a mountainous region.
From 2002 to 2005, the economic landscape appeared especially changeable, with the contours shaped by lower wealth, lingering job losses, and looming disinflation. To Fed officials at the time, this indicated that the equilibrium funds rate was unusually low. Simply, the only way to provide lift to an economy in which resource use was slack and inflation pointed down was to keep policy accommodative relative to longer-term standards.
That was then. Now, policy during the period is seen as fueling a housing bubble.
The Fed is guilty as charged in setting policy to achieve the goals mandated in the law. Fed policy makers cannot be held responsible for the fuel to speculative fires provided by foreign saving and the thin compensation for risk that satisfied global investors. Nor can the chain of subsequent mistakes that drove a downturn into a debacle be laid at the feet of the Federal Open Market Committee of 2002 to 2005. If the results seem less than desirable in retrospect, change the law those policy makers were following, but do not blame them for following prevailing law.
Mr. Reinhart is a resident scholar at the American Enterprise Institute. From August 2001 to June 2007, he was the secretary and economist of the Federal Open Market Committee.
Thursday, March 19, 2009
The Fed Did Not Cause the Housing Bubble
Alan Greenspan
We are in the midst of a global crisis that will unquestionably rank as the most virulent since the 1930s. It will eventually subside and pass into history. But how the interacting and reinforcing causes and effects of this severe contraction are interpreted will shape the reconfiguration of our currently disabled global financial system.
There are at least two broad and competing explanations of the origins of this crisis. The first is that the "easy money" policies of the Federal Reserve produced the U.S. housing bubble that is at the core of today's financial mess.
The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages. Between 2002 and 2005, home mortgage rates led U.S. home price change by 11 months. This correlation between home prices and mortgage rates was highly significant, and a far better indicator of rising home prices than the fed-funds rate.
This should not come as a surprise. After all, the prices of long-lived assets have always been determined by discounting the flow of income (or imputed services) by interest rates of the same maturities as the life of the asset. No one, to my knowledge, employs overnight interest rates -- such as the fed-funds rate -- to determine the capitalization rate of real estate, whether it be an office building or a single-family residence.
The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. Moreover, the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier -- in the wake of the emergence, beginning around the turn of this century, of a well arbitraged global market for long-term debt instruments.
U.S. mortgage rates' linkage to short-term U.S. rates had been close for decades. Between 1971 and 2002, the fed-funds rate and the mortgage rate moved in lockstep. The correlation between them was a tight 0.85. Between 2002 and 2005, however, the correlation diminished to insignificance.
As I noted on this page in December 2007, the presumptive cause of the world-wide decline in long-term rates was the tectonic shift in the early 1990s by much of the developing world from heavy emphasis on central planning to increasingly dynamic, export-led market competition. The result was a surge in growth in China and a large number of other emerging market economies that led to an excess of global intended savings relative to intended capital investment. That ex ante excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005.
That decline in long-term interest rates across a wide spectrum of countries statistically explains, and is the most likely major cause of, real-estate capitalization rates that declined and converged across the globe, resulting in the global housing price bubble. (The U.S. price bubble was at, or below, the median according to the International Monetary Fund.) By 2006, long-term interest rates and the home mortgage rates driven by them, for all developed and the main developing economies, had declined to single digits -- I believe for the first time ever. I would have thought that the weight of such evidence would lead to wide support for this as a global explanation of the current crisis.
However, starting in mid-2007, history began to be rewritten, in large part by my good friend and former colleague, Stanford University Professor John Taylor, with whom I have rarely disagreed. Yet writing in these pages last month, Mr. Taylor unequivocally claimed that had the Federal Reserve from 2003-2005 kept short-term interest rates at the levels implied by his "Taylor Rule," "it would have prevented this housing boom and bust. "This notion has been cited and repeated so often that it has taken on the aura of conventional wisdom.
Aside from the inappropriate use of short-term rates to explain the value of long-term assets, his statistical indictment of Federal Reserve policy in the period 2003-2005 fails to address the aforementioned extraordinary structural developments in the global economy. His statistical analysis carries empirical relationships of earlier decades into the most recent period where they no longer apply.
Moreover, while I believe the "Taylor Rule" is a useful first approximation to the path of monetary policy, its parameters and predictions derive from model structures that have been consistently unable to anticipate the onset of recessions or financial crises. Counterfactuals from such flawed structures cannot form the sole basis for successful policy analysis or advice, with or without the benefit of hindsight.
Given the decoupling of monetary policy from long-term mortgage rates, accelerating the path of monetary tightening that the Fed pursued in 2004-2005 could not have "prevented" the housing bubble. All things considered, I personally prefer Milton Friedman's performance appraisal of the Federal Reserve. In evaluating the period of 1987 to 2005, he wrote on this page in early 2006: "There is no other period of comparable length in which the Federal Reserve System has performed so well. It is more than a difference of degree; it approaches a difference of kind."
How much does it matter whether the bubble was caused by inappropriate monetary policy, over which policy makers have control, or broader global forces over which their control is limited? A great deal.
If it is monetary policy that is at fault, then that can be corrected in the future, at least in principle. If, however, we are dealing with global forces beyond the control of domestic monetary policy makers, as I strongly suspect is the case, then we are facing a broader issue.
Global market competition and integration in goods, services and finance have brought unprecedented gains in material well being. But the growth path of highly competitive markets is cyclical. And on rare occasions it can break down, with consequences such as those we are currently experiencing. It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk-management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.
However, the appropriate policy response is not to bridle financial intermediation with heavy regulation. That would stifle important advances in finance that enhance standards of living. Remember, prior to the crisis, the U.S. economy exhibited an impressive degree of productivity advance. To achieve that with a modest level of combined domestic and borrowed foreign savings (our current account deficit) was a measure of our financial system's precrisis success. The solutions for the financial-market failures revealed by the crisis are higher capital requirements and a wider prosecution of fraud -- not increased micromanagement by government entities.
Any new regulations should improve the ability of financial institutions to effectively direct a nation's savings into the most productive capital investments. Much regulation fails that test, and is often costly and counterproductive. Adequate capital and collateral requirements can address the weaknesses that the crisis has unearthed. Such requirements will not be overly intrusive, and thus will not interfere unduly in private-sector business decisions.
If we are to retain a dynamic world economy capable of producing prosperity and future sustainable growth, we cannot rely on governments to intermediate saving and investment flows. Our challenge in the months ahead will be to install a regulatory regime that will ensure responsible risk management on the part of financial institutions, while encouraging them to continue taking the risks necessary and inherent in any successful market economy.
Mr. Greenspan, former chairman of the Federal Reserve, is president of Greenspan Associates LLC and author of "The Age of Turbulence: Adventures in a New World" (Penguin, 2007).
We are in the midst of a global crisis that will unquestionably rank as the most virulent since the 1930s. It will eventually subside and pass into history. But how the interacting and reinforcing causes and effects of this severe contraction are interpreted will shape the reconfiguration of our currently disabled global financial system.
There are at least two broad and competing explanations of the origins of this crisis. The first is that the "easy money" policies of the Federal Reserve produced the U.S. housing bubble that is at the core of today's financial mess.
The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages. Between 2002 and 2005, home mortgage rates led U.S. home price change by 11 months. This correlation between home prices and mortgage rates was highly significant, and a far better indicator of rising home prices than the fed-funds rate.
This should not come as a surprise. After all, the prices of long-lived assets have always been determined by discounting the flow of income (or imputed services) by interest rates of the same maturities as the life of the asset. No one, to my knowledge, employs overnight interest rates -- such as the fed-funds rate -- to determine the capitalization rate of real estate, whether it be an office building or a single-family residence.
The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. Moreover, the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier -- in the wake of the emergence, beginning around the turn of this century, of a well arbitraged global market for long-term debt instruments.
U.S. mortgage rates' linkage to short-term U.S. rates had been close for decades. Between 1971 and 2002, the fed-funds rate and the mortgage rate moved in lockstep. The correlation between them was a tight 0.85. Between 2002 and 2005, however, the correlation diminished to insignificance.
As I noted on this page in December 2007, the presumptive cause of the world-wide decline in long-term rates was the tectonic shift in the early 1990s by much of the developing world from heavy emphasis on central planning to increasingly dynamic, export-led market competition. The result was a surge in growth in China and a large number of other emerging market economies that led to an excess of global intended savings relative to intended capital investment. That ex ante excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005.
That decline in long-term interest rates across a wide spectrum of countries statistically explains, and is the most likely major cause of, real-estate capitalization rates that declined and converged across the globe, resulting in the global housing price bubble. (The U.S. price bubble was at, or below, the median according to the International Monetary Fund.) By 2006, long-term interest rates and the home mortgage rates driven by them, for all developed and the main developing economies, had declined to single digits -- I believe for the first time ever. I would have thought that the weight of such evidence would lead to wide support for this as a global explanation of the current crisis.
However, starting in mid-2007, history began to be rewritten, in large part by my good friend and former colleague, Stanford University Professor John Taylor, with whom I have rarely disagreed. Yet writing in these pages last month, Mr. Taylor unequivocally claimed that had the Federal Reserve from 2003-2005 kept short-term interest rates at the levels implied by his "Taylor Rule," "it would have prevented this housing boom and bust. "This notion has been cited and repeated so often that it has taken on the aura of conventional wisdom.
Aside from the inappropriate use of short-term rates to explain the value of long-term assets, his statistical indictment of Federal Reserve policy in the period 2003-2005 fails to address the aforementioned extraordinary structural developments in the global economy. His statistical analysis carries empirical relationships of earlier decades into the most recent period where they no longer apply.
Moreover, while I believe the "Taylor Rule" is a useful first approximation to the path of monetary policy, its parameters and predictions derive from model structures that have been consistently unable to anticipate the onset of recessions or financial crises. Counterfactuals from such flawed structures cannot form the sole basis for successful policy analysis or advice, with or without the benefit of hindsight.
Given the decoupling of monetary policy from long-term mortgage rates, accelerating the path of monetary tightening that the Fed pursued in 2004-2005 could not have "prevented" the housing bubble. All things considered, I personally prefer Milton Friedman's performance appraisal of the Federal Reserve. In evaluating the period of 1987 to 2005, he wrote on this page in early 2006: "There is no other period of comparable length in which the Federal Reserve System has performed so well. It is more than a difference of degree; it approaches a difference of kind."
How much does it matter whether the bubble was caused by inappropriate monetary policy, over which policy makers have control, or broader global forces over which their control is limited? A great deal.
If it is monetary policy that is at fault, then that can be corrected in the future, at least in principle. If, however, we are dealing with global forces beyond the control of domestic monetary policy makers, as I strongly suspect is the case, then we are facing a broader issue.
Global market competition and integration in goods, services and finance have brought unprecedented gains in material well being. But the growth path of highly competitive markets is cyclical. And on rare occasions it can break down, with consequences such as those we are currently experiencing. It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk-management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.
However, the appropriate policy response is not to bridle financial intermediation with heavy regulation. That would stifle important advances in finance that enhance standards of living. Remember, prior to the crisis, the U.S. economy exhibited an impressive degree of productivity advance. To achieve that with a modest level of combined domestic and borrowed foreign savings (our current account deficit) was a measure of our financial system's precrisis success. The solutions for the financial-market failures revealed by the crisis are higher capital requirements and a wider prosecution of fraud -- not increased micromanagement by government entities.
Any new regulations should improve the ability of financial institutions to effectively direct a nation's savings into the most productive capital investments. Much regulation fails that test, and is often costly and counterproductive. Adequate capital and collateral requirements can address the weaknesses that the crisis has unearthed. Such requirements will not be overly intrusive, and thus will not interfere unduly in private-sector business decisions.
If we are to retain a dynamic world economy capable of producing prosperity and future sustainable growth, we cannot rely on governments to intermediate saving and investment flows. Our challenge in the months ahead will be to install a regulatory regime that will ensure responsible risk management on the part of financial institutions, while encouraging them to continue taking the risks necessary and inherent in any successful market economy.
Mr. Greenspan, former chairman of the Federal Reserve, is president of Greenspan Associates LLC and author of "The Age of Turbulence: Adventures in a New World" (Penguin, 2007).
Sunday, March 01, 2009
Why Stimulus Will Mean Inflation
By GEORGE MELLOAN
As Congress blithely ushers its trillion dollar "stimulus" package toward law and the U.S. Treasury prepares to begin writing checks on this vast new appropriation, it might be wise to ask a simple question: Who's going to finance it?
That might seem like a no-brainer, which perhaps explains why no one has bothered to ask. Treasury securities are selling at high prices and finding buyers even though yields are low, hovering below 3% for 10-year notes. Congress is able to assure itself that it will finance the stimulus with cheap credit. But how long will credit be cheap? Will it still be when the Treasury is scrounging around in the international credit markets six months or a year from now? That seems highly unlikely.
Let's have a look at the credit market. Treasurys have been strong because the stock market collapse and the mortgage-backed securities fiasco sent the whole world running for safety. The best looking port in the storm, as usual, was U.S. Treasury paper. That is what gave the dollar and Treasury securities the lift they now enjoy.
But that surge was a one-time event and doesn't necessarily mean that a big new batch of Treasury securities will find an equally strong market. Most likely it won't as the global economy spirals downward.
For one thing, a very important cycle has been interrupted by the crash. For years, the U.S. has run large trade deficits with China and Japan and those two countries have invested their surpluses mostly in U.S. Treasury securities. Their holdings are enormous: As of Nov. 30 last year, China held $682 billion in Treasurys, a sharp rise from $459 billion a year earlier. Japan had reduced its holdings, to $577 billion from $590 billion a year earlier, but remains a huge creditor. The two account for almost 65% of total Treasury securities held by foreign owners, 19% of the total U.S. national debt, and over 30% of Treasurys held by the public.
In the lush years of the U.S. credit boom, it was rationalized that this circular arrangement was good for all concerned. Exports fueled China's rapid economic growth and created jobs for its huge work force, American workers could raise their living standards by buying cheap Chinese goods. China's dollar surplus gave the U.S. Treasury a captive pool of investment to finance congressional deficits. It was argued, persuasively, that China and Japan had no choice but to buy U.S. bonds if they wanted to keep their exports to the U.S. flowing. They also would hurt their own interests if they tried to unload Treasurys because that would send the value of their remaining holdings down.
But what if they stopped buying bonds not out of choice but because they were out of money? The virtuous circle so much praised would be broken. Something like that seems to be happening now. As the recession deepens, U.S. consumers are spending less, even on cheap Chinese goods and certainly on Japanese cars and electronic products. Japan, already a smaller market for U.S. debt last November, is now suffering what some have described as "free fall" in industrial production. Its two champions, Toyota and Sony, are faltering badly. China's growth also is slowing, and it is plagued by rising unemployment.
American officials seem not to have noticed this abrupt and dangerous change in global patterns of trade and finance. The new Treasury secretary, Timothy Geithner, at his Senate confirmation hearing harped on that old Treasury mantra about China "manipulating" its currency to gain trade advantage. Vice President Joe Biden followed up with a further lecture to the Chinese but said the U.S. will not move "unilaterally" to keep out Chinese exports. One would hope not "unilaterally" or any other way if the U.S. hopes to keep flogging its Treasurys to the Chinese.
The Congressional Budget Office is predicting the federal deficit will reach $1.2 trillion this fiscal year. That's more than double the $455 billion deficit posted for fiscal 2008, and some private estimates put the likely outcome even higher. That will drive up interest costs in the federal budget even if Treasury yields stay low. But if a drop in world market demand for Treasurys sends borrowing costs upward, there could be a ballooning of the interest cost line in the budget that will worsen an already frightening outlook. Credit for the rest of the economy will become more dear as well, worsening the recession. Treasury's Wednesday announcement that it will sell a record $67 billion in notes and bonds next week and $493 billion in this quarter weakened Treasury prices, revealing market sensitivity to heavy financing.
So what is the outlook? The stimulus package is rolling through Congress like an express train packed with goodies, so an enormous deficit seems to be a given. Entitlements will go up instead of being brought under better control, auguring big future deficits. Where will the Treasury find all those trillions in a depressed world economy?
There is only one answer. The Obama administration and Congress will call on Ben Bernanke at the Fed to demand that he create more dollars -- lots and lots of them. The Fed already is talking of buying longer-term Treasurys to support the market, so it will be more of the same -- much more.
And what will be the result? Well, the product of this sort of thing is called inflation. The Fed's outpouring of dollar liquidity after the September crash replaced the liquidity lost by the financial sector and has so far caused no significant uptick in consumer prices. But the worry lies in what will happen next.
Even when the economy and the securities markets are sluggish, the Fed's financing of big federal deficits can be inflationary. We learned that in the late 1970s, when the Fed's deficit financing sent the CPI up to an annual rate of almost 15%. That confounded the Keynesian theorists who believed then, as now, that federal spending "stimulus" would restore economic health.
Inflation is the product of the demand for money as well as of the supply. And if the Fed finances federal deficits in a moribund economy, it can create more money than the economy can use. The result is "stagflation," a term coined to describe the 1970s experience. As the global economy slows and Congress relies more on the Fed to finance a huge deficit, there is a very real danger of a return of stagflation. I wonder why no one in Congress or the Obama administration has thought of that as a potential consequence of their stimulus package.
As Congress blithely ushers its trillion dollar "stimulus" package toward law and the U.S. Treasury prepares to begin writing checks on this vast new appropriation, it might be wise to ask a simple question: Who's going to finance it?
That might seem like a no-brainer, which perhaps explains why no one has bothered to ask. Treasury securities are selling at high prices and finding buyers even though yields are low, hovering below 3% for 10-year notes. Congress is able to assure itself that it will finance the stimulus with cheap credit. But how long will credit be cheap? Will it still be when the Treasury is scrounging around in the international credit markets six months or a year from now? That seems highly unlikely.
Let's have a look at the credit market. Treasurys have been strong because the stock market collapse and the mortgage-backed securities fiasco sent the whole world running for safety. The best looking port in the storm, as usual, was U.S. Treasury paper. That is what gave the dollar and Treasury securities the lift they now enjoy.
But that surge was a one-time event and doesn't necessarily mean that a big new batch of Treasury securities will find an equally strong market. Most likely it won't as the global economy spirals downward.
For one thing, a very important cycle has been interrupted by the crash. For years, the U.S. has run large trade deficits with China and Japan and those two countries have invested their surpluses mostly in U.S. Treasury securities. Their holdings are enormous: As of Nov. 30 last year, China held $682 billion in Treasurys, a sharp rise from $459 billion a year earlier. Japan had reduced its holdings, to $577 billion from $590 billion a year earlier, but remains a huge creditor. The two account for almost 65% of total Treasury securities held by foreign owners, 19% of the total U.S. national debt, and over 30% of Treasurys held by the public.
In the lush years of the U.S. credit boom, it was rationalized that this circular arrangement was good for all concerned. Exports fueled China's rapid economic growth and created jobs for its huge work force, American workers could raise their living standards by buying cheap Chinese goods. China's dollar surplus gave the U.S. Treasury a captive pool of investment to finance congressional deficits. It was argued, persuasively, that China and Japan had no choice but to buy U.S. bonds if they wanted to keep their exports to the U.S. flowing. They also would hurt their own interests if they tried to unload Treasurys because that would send the value of their remaining holdings down.
But what if they stopped buying bonds not out of choice but because they were out of money? The virtuous circle so much praised would be broken. Something like that seems to be happening now. As the recession deepens, U.S. consumers are spending less, even on cheap Chinese goods and certainly on Japanese cars and electronic products. Japan, already a smaller market for U.S. debt last November, is now suffering what some have described as "free fall" in industrial production. Its two champions, Toyota and Sony, are faltering badly. China's growth also is slowing, and it is plagued by rising unemployment.
American officials seem not to have noticed this abrupt and dangerous change in global patterns of trade and finance. The new Treasury secretary, Timothy Geithner, at his Senate confirmation hearing harped on that old Treasury mantra about China "manipulating" its currency to gain trade advantage. Vice President Joe Biden followed up with a further lecture to the Chinese but said the U.S. will not move "unilaterally" to keep out Chinese exports. One would hope not "unilaterally" or any other way if the U.S. hopes to keep flogging its Treasurys to the Chinese.
The Congressional Budget Office is predicting the federal deficit will reach $1.2 trillion this fiscal year. That's more than double the $455 billion deficit posted for fiscal 2008, and some private estimates put the likely outcome even higher. That will drive up interest costs in the federal budget even if Treasury yields stay low. But if a drop in world market demand for Treasurys sends borrowing costs upward, there could be a ballooning of the interest cost line in the budget that will worsen an already frightening outlook. Credit for the rest of the economy will become more dear as well, worsening the recession. Treasury's Wednesday announcement that it will sell a record $67 billion in notes and bonds next week and $493 billion in this quarter weakened Treasury prices, revealing market sensitivity to heavy financing.
So what is the outlook? The stimulus package is rolling through Congress like an express train packed with goodies, so an enormous deficit seems to be a given. Entitlements will go up instead of being brought under better control, auguring big future deficits. Where will the Treasury find all those trillions in a depressed world economy?
There is only one answer. The Obama administration and Congress will call on Ben Bernanke at the Fed to demand that he create more dollars -- lots and lots of them. The Fed already is talking of buying longer-term Treasurys to support the market, so it will be more of the same -- much more.
And what will be the result? Well, the product of this sort of thing is called inflation. The Fed's outpouring of dollar liquidity after the September crash replaced the liquidity lost by the financial sector and has so far caused no significant uptick in consumer prices. But the worry lies in what will happen next.
Even when the economy and the securities markets are sluggish, the Fed's financing of big federal deficits can be inflationary. We learned that in the late 1970s, when the Fed's deficit financing sent the CPI up to an annual rate of almost 15%. That confounded the Keynesian theorists who believed then, as now, that federal spending "stimulus" would restore economic health.
Inflation is the product of the demand for money as well as of the supply. And if the Fed finances federal deficits in a moribund economy, it can create more money than the economy can use. The result is "stagflation," a term coined to describe the 1970s experience. As the global economy slows and Congress relies more on the Fed to finance a huge deficit, there is a very real danger of a return of stagflation. I wonder why no one in Congress or the Obama administration has thought of that as a potential consequence of their stimulus package.
Deregulation and the Financial Panic
By Phil Gramm
The debate about the cause of the current crisis in our financial markets is important because the reforms implemented by Congress will be profoundly affected by what people believe caused the crisis.
President Bill Clinton signs the Financial Services Modernization Act of 1999.
If the cause was an unsustainable boom in house prices and irresponsible mortgage lending that corrupted the balance sheets of the world's financial institutions, reforming the housing credit system and correcting attendant problems in the financial system are called for. But if the fundamental structure of the financial system is flawed, a more profound restructuring is required.
I believe that a strong case can be made that the financial crisis stemmed from a confluence of two factors. The first was the unintended consequences of a monetary policy, developed to combat inventory cycle recessions in the last half of the 20th century, that was not well suited to the speculative bubble recession of 2001. The second was the politicization of mortgage lending.
The 2001 recession was brought on when a speculative bubble in the equity market burst, causing investment to collapse. But unlike previous postwar recessions, consumption and the housing industry remained strong at the trough of the recession. Critics of Federal Reserve Chairman Alan Greenspan say he held interest rates too low for too long, and in the process overstimulated the economy. That criticism does not capture what went wrong, however. The consequences of the Fed's monetary policy lay elsewhere.
In the inventory-cycle recessions experienced in the last half of the 20th century, involuntary build up of inventories produced retrenchment in the production chain. Workers were laid off and investment and consumption, including the housing sector, slumped.
In the 2001 recession, however, consumption and home building remained strong as investment collapsed. The Fed's sharp, prolonged reduction in interest rates stimulated a housing market that was already booming -- triggering six years of double-digit increases in housing prices during a period when the general inflation rate was low.
Buyers bought houses they couldn't afford, believing they could refinance in the future and benefit from the ongoing appreciation. Lenders assumed that even if everything else went wrong, properties could still be sold for more than they cost and the loan could be repaid. This mentality permeated the market from the originator to the holder of securitized mortgages, from the rating agency to the financial regulator.
Meanwhile, mortgage lending was becoming increasingly politicized. Community Reinvestment Act (CRA) requirements led regulators to foster looser underwriting and encouraged the making of more and more marginal loans. Looser underwriting standards spread beyond subprime to the whole housing market.
As Mr. Greenspan testified last October at a hearing of the House Committee on Oversight and Government Reform, "It's instructive to go back to the early stages of the subprime market, which has essentially emerged out of CRA." It was not just that CRA and federal housing policy pressured lenders to make risky loans -- but that they gave lenders the excuse and the regulatory cover.
Countrywide Financial Corp. cloaked itself in righteousness and silenced any troubled regulator by being the first mortgage lender to sign a HUD "Declaration of Fair Lending Principles and Practices." Given privileged status by Fannie Mae as a reward for "the most flexible underwriting criteria," it became the world's largest mortgage lender -- until it became the first major casualty of the financial crisis.
The 1992 Housing Bill set quotas or "targets" that Fannie and Freddie were to achieve in meeting the housing needs of low- and moderate-income Americans. In 1995 HUD raised the primary quota for low- and moderate-income housing loans from the 30% set by Congress in 1992 to 40% in 1996 and to 42% in 1997.
By the time the housing market collapsed, Fannie and Freddie faced three quotas. The first was for mortgages to individuals with below-average income, set at 56% of their overall mortgage holdings. The second targeted families with incomes at or below 60% of area median income, set at 27% of their holdings. The third targeted geographic areas deemed to be underserved, set at 35%.
The results? In 1994, 4.5% of the mortgage market was subprime and 31% of those subprime loans were securitized. By 2006, 20.1% of the entire mortgage market was subprime and 81% of those loans were securitized. The Congressional Budget Office now estimates that GSE losses will cost $240 billion in fiscal year 2009. If this crisis proves nothing else, it proves you cannot help people by lending them more money than they can pay back.
Blinded by the experience of the postwar period, where aggregate housing prices had never declined on an annual basis, and using the last 20 years as a measure of the norm, rating agencies and regulators viewed securitized mortgages, even subprime and undocumented Alt-A mortgages, as embodying little risk. It was not that regulators were not empowered; it was that they were not alarmed.
With near universal approval of regulators world-wide, these securities were injected into the arteries of the world's financial system. When the bubble burst, the financial system lost the indispensable ingredients of confidence and trust. We all know the rest of the story.
The principal alternative to the politicization of mortgage lending and bad monetary policy as causes of the financial crisis is deregulation. How deregulation caused the crisis has never been specifically explained. Nevertheless, two laws are most often blamed: the Gramm-Leach-Bliley (GLB) Act of 1999 and the Commodity Futures Modernization Act of 2000.
GLB repealed part of the Great Depression era Glass-Steagall Act, and allowed banks, securities companies and insurance companies to affiliate under a Financial Services Holding Company. It seems clear that if GLB was the problem, the crisis would have been expected to have originated in Europe where they never had Glass-Steagall requirements to begin with. Also, the financial firms that failed in this crisis, like Lehman, were the least diversified and the ones that survived, like J.P. Morgan, were the most diversified.
Moreover, GLB didn't deregulate anything. It established the Federal Reserve as a superregulator, overseeing all Financial Services Holding Companies. All activities of financial institutions continued to be regulated on a functional basis by the regulators that had regulated those activities prior to GLB.
When no evidence was ever presented to link GLB to the financial crisis -- and when former President Bill Clinton gave a spirited defense of this law, which he signed -- proponents of the deregulation thesis turned to the Commodity Futures Modernization Act (CFMA), and specifically to credit default swaps.
Yet it is amazing how well the market for credit default swaps has functioned during the financial crisis. That market has never lost liquidity and the default rate has been low, given the general state of the underlying assets. In any case, the CFMA did not deregulate credit default swaps. All swaps were given legal certainty by clarifying that swaps were not futures, but remained subject to regulation just as before based on who issued the swap and the nature of the underlying contracts.
In reality the financial "deregulation" of the last two decades has been greatly exaggerated. As the housing crisis mounted, financial regulators had more power, larger budgets and more personnel than ever. And yet, with the notable exception of Mr. Greenspan's warning about the risk posed by the massive mortgage holdings of Fannie and Freddie, regulators seemed unalarmed as the crisis grew. There is absolutely no evidence that if financial regulators had had more resources or more authority that anything would have been different.
Since politicization of the mortgage market was a primary cause of this crisis, we should be especially careful to prevent the politicization of the banks that have been given taxpayer assistance. Did Citi really change its view on mortgage cram-downs or was it pressured? How much pressure was really applied to force Bank of America to go through with the Merrill acquisition?
Restrictions on executive compensation are good fun for politicians, but they are just one step removed from politicians telling banks who to lend to and for what. We have been down that road before, and we know where it leads.
Finally, it should give us pause in responding to the financial crisis of today to realize that this crisis itself was in part an unintended consequence of the monetary policy we employed to deal with the previous recession. Surely, unintended consequences are a real danger when the monetary base has been bloated by a doubling of the Federal Reserve's balance sheet, and the federal deficit seems destined to exceed $1.7 trillion.
The debate about the cause of the current crisis in our financial markets is important because the reforms implemented by Congress will be profoundly affected by what people believe caused the crisis.
President Bill Clinton signs the Financial Services Modernization Act of 1999.
If the cause was an unsustainable boom in house prices and irresponsible mortgage lending that corrupted the balance sheets of the world's financial institutions, reforming the housing credit system and correcting attendant problems in the financial system are called for. But if the fundamental structure of the financial system is flawed, a more profound restructuring is required.
I believe that a strong case can be made that the financial crisis stemmed from a confluence of two factors. The first was the unintended consequences of a monetary policy, developed to combat inventory cycle recessions in the last half of the 20th century, that was not well suited to the speculative bubble recession of 2001. The second was the politicization of mortgage lending.
The 2001 recession was brought on when a speculative bubble in the equity market burst, causing investment to collapse. But unlike previous postwar recessions, consumption and the housing industry remained strong at the trough of the recession. Critics of Federal Reserve Chairman Alan Greenspan say he held interest rates too low for too long, and in the process overstimulated the economy. That criticism does not capture what went wrong, however. The consequences of the Fed's monetary policy lay elsewhere.
In the inventory-cycle recessions experienced in the last half of the 20th century, involuntary build up of inventories produced retrenchment in the production chain. Workers were laid off and investment and consumption, including the housing sector, slumped.
In the 2001 recession, however, consumption and home building remained strong as investment collapsed. The Fed's sharp, prolonged reduction in interest rates stimulated a housing market that was already booming -- triggering six years of double-digit increases in housing prices during a period when the general inflation rate was low.
Buyers bought houses they couldn't afford, believing they could refinance in the future and benefit from the ongoing appreciation. Lenders assumed that even if everything else went wrong, properties could still be sold for more than they cost and the loan could be repaid. This mentality permeated the market from the originator to the holder of securitized mortgages, from the rating agency to the financial regulator.
Meanwhile, mortgage lending was becoming increasingly politicized. Community Reinvestment Act (CRA) requirements led regulators to foster looser underwriting and encouraged the making of more and more marginal loans. Looser underwriting standards spread beyond subprime to the whole housing market.
As Mr. Greenspan testified last October at a hearing of the House Committee on Oversight and Government Reform, "It's instructive to go back to the early stages of the subprime market, which has essentially emerged out of CRA." It was not just that CRA and federal housing policy pressured lenders to make risky loans -- but that they gave lenders the excuse and the regulatory cover.
Countrywide Financial Corp. cloaked itself in righteousness and silenced any troubled regulator by being the first mortgage lender to sign a HUD "Declaration of Fair Lending Principles and Practices." Given privileged status by Fannie Mae as a reward for "the most flexible underwriting criteria," it became the world's largest mortgage lender -- until it became the first major casualty of the financial crisis.
The 1992 Housing Bill set quotas or "targets" that Fannie and Freddie were to achieve in meeting the housing needs of low- and moderate-income Americans. In 1995 HUD raised the primary quota for low- and moderate-income housing loans from the 30% set by Congress in 1992 to 40% in 1996 and to 42% in 1997.
By the time the housing market collapsed, Fannie and Freddie faced three quotas. The first was for mortgages to individuals with below-average income, set at 56% of their overall mortgage holdings. The second targeted families with incomes at or below 60% of area median income, set at 27% of their holdings. The third targeted geographic areas deemed to be underserved, set at 35%.
The results? In 1994, 4.5% of the mortgage market was subprime and 31% of those subprime loans were securitized. By 2006, 20.1% of the entire mortgage market was subprime and 81% of those loans were securitized. The Congressional Budget Office now estimates that GSE losses will cost $240 billion in fiscal year 2009. If this crisis proves nothing else, it proves you cannot help people by lending them more money than they can pay back.
Blinded by the experience of the postwar period, where aggregate housing prices had never declined on an annual basis, and using the last 20 years as a measure of the norm, rating agencies and regulators viewed securitized mortgages, even subprime and undocumented Alt-A mortgages, as embodying little risk. It was not that regulators were not empowered; it was that they were not alarmed.
With near universal approval of regulators world-wide, these securities were injected into the arteries of the world's financial system. When the bubble burst, the financial system lost the indispensable ingredients of confidence and trust. We all know the rest of the story.
The principal alternative to the politicization of mortgage lending and bad monetary policy as causes of the financial crisis is deregulation. How deregulation caused the crisis has never been specifically explained. Nevertheless, two laws are most often blamed: the Gramm-Leach-Bliley (GLB) Act of 1999 and the Commodity Futures Modernization Act of 2000.
GLB repealed part of the Great Depression era Glass-Steagall Act, and allowed banks, securities companies and insurance companies to affiliate under a Financial Services Holding Company. It seems clear that if GLB was the problem, the crisis would have been expected to have originated in Europe where they never had Glass-Steagall requirements to begin with. Also, the financial firms that failed in this crisis, like Lehman, were the least diversified and the ones that survived, like J.P. Morgan, were the most diversified.
Moreover, GLB didn't deregulate anything. It established the Federal Reserve as a superregulator, overseeing all Financial Services Holding Companies. All activities of financial institutions continued to be regulated on a functional basis by the regulators that had regulated those activities prior to GLB.
When no evidence was ever presented to link GLB to the financial crisis -- and when former President Bill Clinton gave a spirited defense of this law, which he signed -- proponents of the deregulation thesis turned to the Commodity Futures Modernization Act (CFMA), and specifically to credit default swaps.
Yet it is amazing how well the market for credit default swaps has functioned during the financial crisis. That market has never lost liquidity and the default rate has been low, given the general state of the underlying assets. In any case, the CFMA did not deregulate credit default swaps. All swaps were given legal certainty by clarifying that swaps were not futures, but remained subject to regulation just as before based on who issued the swap and the nature of the underlying contracts.
In reality the financial "deregulation" of the last two decades has been greatly exaggerated. As the housing crisis mounted, financial regulators had more power, larger budgets and more personnel than ever. And yet, with the notable exception of Mr. Greenspan's warning about the risk posed by the massive mortgage holdings of Fannie and Freddie, regulators seemed unalarmed as the crisis grew. There is absolutely no evidence that if financial regulators had had more resources or more authority that anything would have been different.
Since politicization of the mortgage market was a primary cause of this crisis, we should be especially careful to prevent the politicization of the banks that have been given taxpayer assistance. Did Citi really change its view on mortgage cram-downs or was it pressured? How much pressure was really applied to force Bank of America to go through with the Merrill acquisition?
Restrictions on executive compensation are good fun for politicians, but they are just one step removed from politicians telling banks who to lend to and for what. We have been down that road before, and we know where it leads.
Finally, it should give us pause in responding to the financial crisis of today to realize that this crisis itself was in part an unintended consequence of the monetary policy we employed to deal with the previous recession. Surely, unintended consequences are a real danger when the monetary base has been bloated by a doubling of the Federal Reserve's balance sheet, and the federal deficit seems destined to exceed $1.7 trillion.
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