Posts Tagged The Crisis of 2008
I recently stumbled upon a reddit post called ‘A collection of links every critic of economics should read.‘ One of the weaker links is a defence of economists post-crisis by Gilles Saint-Paul. It doesn’t argue that economists actually did a good job foreseeing the crisis; nor does it argue they have made substantial changes since the crisis. It argues that the crisis is irrelevant. It is, frankly, an exercise in confirmation bias and special pleading, and must be fisked in the name of all that is good and holy.
Saint-Paul starts by exploring the purpose of economists:
If they are academics, they are supposed to move the frontier of research by providing new theories, methodologies, and empirical findings.
Yes, all in the name of explaining what is happening in the real world! If economists claim their discipline is anything more than collective mathematical navel gazing, then their models must have real world corroboration. If this is not yet the case, then progress should be in that direction. Saint-Paul is apparently happy with a situation where economists devise new theories and all nod and stroke their beards, in complete isolation from the real world.
If [economists] work for a public administration, they will quite often evaluate policies.
Hopefully ones that prevent or cushion financial crises, surely? Wait – apparently this is not a major consideration:
One might think that since economists did not forecast the crisis, they are useless. It would be equally ridiculous to say that doctors were useless since they did not forecast AIDS or mad cow disease.
AIDs and mad cow disease were random mutations of existing diseases and so could not have been foreseen. Financial crises are repeated and have occurred throughout history. They demonstrate clear, repeated patterns: debt build ups; asset inflation; slow recoveries. Yet despite this, doctors have made more progress on AIDs and MCD in a few decades than economists have on financial crises in a few centuries. It was worrying enough that DSGE models were unable to model the Great Depression, but given that ‘it’ has now happened again, under very similar circumstances, you’d think that alarm bells might be going off inside the discipline.
Saint-Paul now starts to defend economics at its most absurd:
One example of a consistent theory is the Black-Scholes option pricing model. Upon its introduction, the theory was adopted by market participants to price options, and thus became a correct model of pricing precisely because people knew it.
Similarly, any macroeconomic theory that, in the midst of the housing bubble, would have predicted a financial crisis two years ahead with certainty would have triggered, by virtue of speculation, an immediate stock market crash and a spiral of de-leveraging and de-intermediation which would have depressed investment and consumption. In other words, the crisis would have happened immediately, not in two years, thus invalidating the theory.
‘A crisis will happen if these steps are not taken to prevent it’ is not the same as ‘Lehman Brothers will collapse for certain on September 15th, 2008.’ Saint-Paul confuses different levels, and types of, prediction. Nobody is suggesting economists should give us a precise date. What people are suggesting is that, by now, economists should know the key causal factors of financial crises and give advice on how to prevent them.
Saint-Paul charges critics with:
…[ignoring] that economics is a science that interacts with the object it is studying.
How he thinks this is beyond me, seeing as the whole criticism is that policies designed by economists had a hand in causing the crash. Predictably, he goes on to state a ‘hard’ version of the Lucas Critique, the go-to argument for economists defending their microfoundations:
Economic knowledge is diffused throughout society and eventually affects the behaviour of economic agents. This in turn alters the working of the economy. Therefore, a model can only be correct if it is consistent with its own feedback effect on how the economy works. An economic theory that does not pass this test may work for a while, but it will turn out to be incorrect as soon as it is widely believed and implemented in the actual plans of firms and consumers. Paradoxically, the only chance for such a theory to be correct is for most people to ignore it.
It is reasonable to suggest policy will have some impact on the behaviour of economic agents. It is absurd to suggest this will always have the effect of rendering the policy (model) useless (irrelevant). It is even more absurd to suggest that we can ever design a model that sidesteps this problem completely. What we have is a continually changing relationship between policy and economic behaviour, and this must be taken into account when designing policy. This doesn’t imply we should fall back on economist’s preferred methods, despite a clear empirical failure.
Saint-Paul moves on – now, apparently, the problem is not that economist’s theories don’t behave like reality, but that reality doesn’t behave like economist’s theories:
In other words, if market participants had been more literate in, or more trustful of economics, the asset bubbles and the crisis might have been avoided.
If only everyone believed, then everything would be fine! Obviously, the simple counterpart to this is that many investors and banks did believe in the EMH or some variant of it, yet, as always, reality had the final say, as happened with the aforementioned Black-Scholes equation.
Saint-Paul now attempts to play the ‘get out of reality completely’ card:
While it is valuable to understand how the economy actually works, it is also valuable to understand how it would behave in an equilibrium situation where the agents’ knowledge of the right model of the economy is consistent with that model, which is what we call a “rational expectations equilibrium”. Just because such equilibria do not describe past data well does not mean they are useless abstraction. Their descriptive failure tells us something about the economy being in an unstable regime, and their predictions tell is something about what a stable regime looks like.
Basically, Saint-Paul is arguing that economic models should be unfalsifiable. Since we can hazard a guess that he isn’t too bothered about unrealistic assumptions, given the models he is defending, and since he clearly doesn’t care about predictions either, he has successfully jumped the shark. Economists want to be left alone to build their models which posit conditions which are never fulfilled in the real world, and that’s final!
As if this wasn’t enough, he proceeds to castigate the idea that economists should even attempt to expand their horizons:
The problem with the “broad picture” approach, regardless of the intellectual quality of those contributions, is that it mostly rests on unproven claims and mechanisms. And in many cases, one is merely speculating that this or that could happen, without even offering a detailed causal chain of events that would rigorously convince the reader that this is an actual possibility.
Note what Saint-Paul means by “detailed causal chain of events.” He means microfoundations. But he is not concerned about whether these microfoundations actually resemble real world mechanics, only that whether they are a “possibility.” To him, the mere validity of an economic argument means that it has been ‘proven,’ regardless of its soundness. In other words: economists shouldn’t be approximately right, but precisely wrong.
Saint-Paul concludes by rejecting the idea that financial crises can be modeled and foreseen:
This presumption may be proven wrong, but to my knowledge proponents of alternative approaches have not yet succeeded in offering us an operational framework with a stronger predictive power.
I hope – and actually believe – that most economists don’t believe that the crisis is irrelevant for their discipline. I’m sure few would endorse the caricature of a view presented here by Saint-Paul. Nevertheless, it is common for economists to suggest that the crisis was unforeseeable: a rare event that cannot be modeled because the economy is too ‘complex.’ This must be combated. Financial crises are actually (unfortunately) relatively frequent occurrences with clear, discernible patterns drawing them together. To paraphrase Hyman Minsky: a macroeconomic model must necessarily be able to find itself in financial crisis, otherwise it is not a model of the real world.
In chapter 14 of Debunking Economics, Steve Keen walks us through the macroeconomic model he has developed in recent years, and discusses the implications its conclusions might have for policy. The model is in its early stages, and Keen himself says there are “many aspects of the model of which [he is] critical.” Nonetheless, it is a promising start to developing an alternative to the dominant DSGE method.
Keen’s is a model of a pure credit economy, with three aggregated agents: workers, firms, and bankers. Instead of focusing on preferences, individuals and market clearing, it focuses on the flow of funds between different sectors. Bankers create their own money in the form of loans*, which at this stage they are only allowed to lend to firms. The firms pay the workers and the interest on the loans, whilst the bankers and workers consume the output of the firms.
The crucial sector here, is, of course, banking, which few neoclassical models include explicitly, as they believe finance plays the role of intermediation between savers and borrowers. However, in Keen’s model the banks are central. He disaggregates them into several accounts: a vault in which to store notes; a safe into which interest is paid and out of which bankers are paid; a loan ledger; firm deposits and worker deposits. The flows between the various agents and accounts are then determined by some arbitrary coefficients, which Keen uses simply to determine whether the model will ‘work’ (i.e. not break down). Each flow (e.g. wages; consumption) is determined by a constant times a stock (e.g. firm’s deposits; worker’s deposits).
This is the point at which economists might scream ‘Lucas Critique,’ but Keen’s comment from an earlier chapter, that is absurd to suggest that any change in policy will have the effect of neutralising arbitrary parameters, applies. Furthermore, there is no theory that is policy-independent, so whilst we must examine the relationship between policy and reality, we cannot render our models immune to it by micro founding them. In any case, the model is in its early stages, and there is plenty of room for adding complexity.
Keen uses this basic model to explore what effect bank bailouts will have. Quelle surprise, bank bailouts have the effect of increasing loans slightly, and benefitting bankers, but don’t do much for the real economy. Conversely, bailing out firms and workers creates a better result for everyone except…the bankers! A small data point can be found in support of this in Australia, where the government bailed out everyone over 18 with $1000, and the economy has performed better than those where the banks have been bailed out. Obviously there are a multitude of conflicting factors, but Keen’s hypothesis does not seem at all unreasonable when taking recent events as whole.
The interesting thing about Keen’s model is that a ‘Great Moderation’ and a ‘Great Recession’ are simply two parts of the same debt-driven process, rather than a ‘black swan’ or some other such event. Debt to GDP rises exponentially in a period of relative tranquility, and this is followed by a huge crash and mass unemployment. A substantial part of this difference from the core DSGE models is created simply by adding banks as explicit agents.
Keen has since developed his model further – he has included ‘Ponzi’ lending, sticky wages/price (which actually stabilise the economy) and a variety of other factors. There is plenty of scope for adding more to the model, such as an exogenously set interest rate with a central bank, but for now the core alone seems to be able to generate behaviour that closely resembles that of a capitalist economy: one prone to cyclical breakdown and intermittent financial crises, not due to any particular ‘friction,’ but due to the inherent characteristics of the system. This should be enough to get any empirically driven economists to pay attention, whether they agree or disagree with the mechanics of the model.
As many readers of this blog will know, Steve Keen is generally the economist credited with best foreseeing and warning about the 2008 financial crash. The 13th chapter of his book is dedicated to showing why his framework foresaw it, and what he did to warn of the coming crisis.
I have seen a few people saying that Keen didn’t really predict the crisis, and what predictions he did make were ‘chicken little’ predictions – repeating “there will be a crisis” until there was one. This is simply not true.
He certainly had the appropriate framework to foresee the financial crisis. His 1995 paper on Minsky and financial instability contains a model prone to endogenous fluctuations, and he concludes that any period of tranquility in a capitalist economy should not be accepted as anything other than a lull before the storm.
The key ingredient in Keen’s framework is, of course, private debt. Since banks create credit ‘out of nothing,’ new private debt adds to nominal aggregate demand. It follows from this that aggregate demand is current income plus the change in debt. I will quote Keen’s numerical example in full to explain why:
Consider an economy with a GDP of $1000 billion that is growing 10% per annum, where this is half due to inflation and half due to real growth, and which has a debt level of $1250 billion that is growing at 20% per annum. AD will therefore be $1250 billion: $1000 billion from GDP, and $250 billion from the increase in debt.
Imagine that the following year, GDP continues to grow at the same 10% rate, but debt growth slows down from 20% per annum to 10%. Demand from income will be $1,100 billion – 10% higher than the previous year – while demand from additional debt will be $150 billion.
Aggregate demand this year will therefore be $1250 billion – exactly the same as the year before. However, since inflation is running at 5%, that will mean a fall in output of 5% – a serious recession. So just a slowdown in the rate of growth of debt can be enough to trigger a recession.
For an economy to grow, either income must increase or private debt must
increase at an increasing rate accelerate; this means that even a slowdown in the rate at which debt is decreasing can create a recovery (as with the US in 2010). The higher the level of private debt relative to income, the more dependent the economy becomes, and the more vulnerable it can be to even a mild slowdown in the rate of change of debt. Thus, in the mid 2000s, when Keen looked up the levels of private debt in developed economies, he was taken aback by the exponential increase:
At this point he went public – most of the evidence for his warning of a coming crisis is from the blog he started, and the monthly reports he released on there, tracking the level of private debt and explaining why it mattered. These reports first analysed the Australian, and then the US economy. He also spoke at a number of events, as well as a few TV and radio appearances which I cannot find online (although the media didn’t really start to take notice until the crisis began).
As a brief aside, I’ve seen a few people mention his failed prediction of the Australian housing crash, and his subsequent having to take a long hike. It is true that he got this one wrong, but there is quite an easy explanation: the government injected a large amount of money into the housing market in the form of first time buyer grants. Coupled with Australia’s resource boom, and the demand from China, this has kept their economy afloat so far.
So the charge that Keen did not predict the crisis, or simply shouted ‘there will be a crisis’ for 10 years until there was one, is false. He has a clear analytical framework that has performed incredibly strongly empirically, both before and throughout the crisis, and he got the dates approximately right (he said 2006). In my next post I will take a more in-depth look at his models and their implications for where we are now.
I like to question almost every aspect of economic orthodoxy. However, I am also interested in forming a coherent view of what is actually wrong with economics, rather than a caricature. So it pains me to see misguided criticisms such as Suzanne Moore’s piece a few weeks back, whose characterisations of economic theory will only serve to misguide the uninformed and elicit dismissive reactions from economists themselves. So here I present a list of things not to highlight when attacking neoclassical economics, in the hope of assisting would-be critics of the discipline.
Criticising early assumptions
Don’t get me wrong, criticising economist’s perversion of the use of assumptions is fair game. However, critics often go down the path of criticising ‘pure rationality’ or ‘perfect information.’ Whilst these are elements of core models (and these models should be attacked because of this, but with the caveat that the core models are the target), they are generally not found in the higher echelons of economics. Many of these assume imperfect information, bounded rationality, and can also incorporate other biases.
Most specifically, idea that economic theory assumes everybody is a selfish, emotionless self-maximiser is common trope, but as Chris Dillow noted in the link above, it’s not entirely true. More importantly, it is also defensible as an assumption – a heuristic by which to approximate behaviour, at least until something better comes along. It is important to distinguish between good and bad assumptions from a scientific standpoint, rather than how absurd they appear to be at first glance.
Many critics of economics, including well-informed ones, make the mistake of arguing that economics always assumes the economy is in equilibrium, tending to equilibrium, oscillating closely around equilibrium, or something along these lines. It is true that many economic models do this; it is also true that economic models start from the assumption that the economy is in equilibrium, and see what happens from there. However, economists generally mean something very different to other scientists when they say equilibrium. From the horse’s mouth:
An equilibrium in an economic model is characterized by two basic conditions which hold in all of the model’s time periods: i) all agents in the model solve the maximization problems implied by their preferences, resource constraints, information sets, etc; and ii) markets for all goods in the model “clear.” An equilibrium is not a snapshot of the model economy at one point in time. Instead, it is the model’s entire time path.
Even on first inspection, this type of equilibrium clearly has problems of its own, but I will save them for another post. The important thing to remember is that this, rather than a stable state, is what economists often mean when they talk about equilibrium.
Economist’s Political Beliefs
Economists are not all free marketeers – in fact, they generally lean to the left. Neoclassical economics, broadly speaking, concludes that we should: regulate oligopolies, monopolies and banking; do more to protect the environment and intervene in the case of other externalities; have some public provision of health, education and welfare; and as that survey shows, economists are generally approving of things such as safety regulations.
As I have said before, I think economic theory as taught lends itself to being used by free marketeers, because of the way the ‘market’ is presented as natural and the government ‘intervenes.’ I also object to the fact that economics applies the same analysis to every market from apples to education to labour. And it is true that the market is presented as generally equilibrating and efficient, except in a few choice cases. However, the impact of these things is not that all economists support ‘right wing’ policy prescriptions, but that neoclassical theory can generally be coopted to provide justification for them.
Naturally, I sympathise with many who try to criticise economics, as they correctly notice that the field’s empirical record (at least in macro) is not great; that many of the policy prescriptions seem to favour the rich whilst hurting the poor; that some of the models taught in economics are unintuitive and perverse. Economists are also partly to blame for not communicating their discipline well to the public, seemingly preferring to dismiss critics as ignorant and revel in their mastery of (what I consider a wholly useless) field.
Having said this, it’s important that in order to engage economists properly, the right questions are asked – ones that economists find difficult to answer. Economists have stock responses to many of the ‘pop’ criticisms of their discipline, so using them will only serve to reinforce economist’s belief in their own knowledge and create further barriers to engagement.
Of course, failing all of this, you can just repeat ‘why didn’t you see the crisis coming?’ over and over.
In 2007/8 asset prices fell because expectations of future NGDP fell which was priced into current asset prices. This lead to a fall in real GDP contemporaneous with a fall in NGDP, but both were caused by fall in expectations of future NGDP as is argued by adherents (cultists?) of NGDP targeting. Asset prices are forward looking and money is an asset, hence you have to look at expectations of future NGDP rather than looking at which moved first by a few months, RGDP or NGDP.
I’m not sure this is the full story. A bubble bursts when people realise that there is no real production underlying the growth of nominal income. If this sounds too economisty, I’ll phrase it in a different way: a bubble bursts when people realise that income is only rising because everyone expects it to rise. Ultimately, NGDP targeting relies on a claim that bubbles are not an important phenomenon for the macroeconomy.
The CB can continue buying assets – even housing – and so spur nominal income, by definition. But does pushing nominal income actually help the real economy? Take a look at this, via Bubbles and Busts:
During the 1970’s the US was plagued by high inflation that at times drifted into the double digits. This led to a brief stint of monetarism at the end of the decade into the early 1980’s. Monetarism, at the time, attempted to target a quantity of money rather than price. As can clearly be seen in this chart, the relationship between NGDP and RGDP is least correlated in the post-WWII period during this time of high inflation and quantity targeting.
For those convinced that NGDP targeting will be successful, the task is to explain why changing policy to promote higher inflation today will not cause a breakdown in the correlation of the past 30 years, similar to the 1970’s. Otherwise it seems perfectly reasonable to expect that NGDP targets will be met with increasing inflation, not real growth.
What’s the point in turning recessions into stagflation?
Left Outside asks what NGDP targeting failure would look like. My answer is either number 1:
NGDP does not reach trend because the bank lacks credibility and the policy is abandoned.
or number 3:
NGDP reaches trend but nominal growth consists (almost) entirely of price changes.
with the possibility that ‘price changes’ are predominantly in various assets, real production is marginally affected, and once the CB runs out of assets to buy we face the mother of all crashes.
NGDP targeting has been catching on across the blogosphere, and, to a more limited extent, in the mainstream. So far, it appears to be the best response to the crisis that mainstream economists can come up with. However, I remain unconvinced – the whole thing, to me, appears to beg a lot of questions.
The rationale for NGDP targeting is roughly as follows: macroeconomic policy can only reliably influence the nominal; the distribution between real income and inflation is determined partly by long run supply-side factors and is partially out of our control. Hence, if we keep nominal spending constant then we will know there is never an AD deficiency – any problems lie elsewhere.
Firstly, I have to agree with Rogue Economist:
Wow. Imagine, business planners and executives will have no more compunctions about claiming to their investors that they will attain at least 5% nominal revenue growth year in year out. If they don’t achieve it via additional sales volume, the Fed is going to make sure they achieve their targets via inflation. Recessions will be a thing of the past. Woohoo!
To believe that we can magically promise stable income growth, no matter the state of anything else in the economy, is to hand wave away the problem of macroeconomics in its entirety. How can it be so easy? Why hasn’t this been adopted before – after all, it’s not a new idea?
The fact is that no rigorous theoretical case has been made that supports NGDP targeting. As evidence, advocates of NGDP targeting offer no more than a graph showing that NGDP declined during the recession, with the implicit assertion that nominal income is what drives the macroeconomy. But is this true? Left Outside’s endorsement of NGDP targeting included this graph, showing that low NGDP is correlated with low RGDP:
This is a clear example of confusing correlation and causation. When looking at two correlated variables, a good question to ask is which one moves first – here, the drop in RGDP clearly precedes the drop in NGDP. This suggests that the decline in RGDP is not a result of the decline in NGDP; rather, its the opposite.
So what happened in 2008? Obviously, the conventional story is true: a large drop in asset prices made many households and firms realise they were less wealthy than they thought; this caused firms to lay off workers; real production decreased; nominal income followed; expectations dropped; this created a spiral. The NGDP-driven story doesn’t withstand scrutiny, else we’d expect the NGDP drop to come first.
Another example of the lack of concrete justification for NGDP targeting is its proponents completely refusal to discuss transmission mechanisms at the zero bound. As we know, government bond yields across the world are about as low as they’re going to get, so ‘traditional’ monetary policy measures are exhausted. What to do?
The CB could begin buying other assets, but that leads us to the question of what happens when these reach the zero bound, or worse, when there are no more assets left to buy. This is at least theoretically possible. Furthermore, there is the obvious observation that merely purchasing assets will not do anything for the real economy. What if NGDP is 5% and RGDP is -5%?
Expectations are often touted as highly important to NGDP targeting, but if expectations are relied on as a transmission mechanism when all other transmission mechanisms become impotent, this undermines itself. For if the CB wishes to make a ‘credible commitment’ to a certain outcome, and this ‘credible commitment’ is vital to the outcome materialising, then that suggests the CB does not have any other way to create the outcome, and hence undermines the credibility of the commitment. To put it another way: the CB can only change things by making people think it will, if it is able to change those things without relying on people thinking it will. Expectations are a product of very real phenomenon, rather than something that can be magically manipulated to produce any desired outcome. Furthermore, even if they could be, evidence suggests that they don’t have that much of an impact.
So the foundation of NGDP targeting – that the CB controls NGDP so they should control NGDP – is completely circular; evidence suggests that nominal spending does not drive the real economy; it is not at all clear exactly how the CB would go about controlling NGDP, and it’s also not clear that targeting NGDP is a particularly desirable policy. Bearing all of this in mind, I’m inclined to agree with Winterspeak - NGDP is just the latest in a long line of mainstream stupidities.
Naturally, I support the endogenous money theory, as it has all the evidence behind it. Economists even seem to acknowledge that the standard textbook story is somewhat behind the times, although they then cling to the money multiplier model, choosing to add epicycles instead of abandoning their core theory (they have a habit of doing this).
As far as I’m concerned, the evidence is so overwhelmingly opposed to exogenous money the burden of proof is on them. So here are a couple of questions:
(1) Why do expansions of the broader measures of money generally precede rather than succeed expansions of the base? Surely in the money multiplier model banks would require reserves before expanding lending? Evidence:
There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the cycle slightly.
(2) A corollary of (1): why do fiat expansions not necessarily result in M1+ expansions? For example 2008:
and similar results can be found during the onset of the Great Depression:
(3) Surely, if banks can create deposits with loans (which they simply can in the real world), by definition a loan adds new purchasing power and increases nominal demand? So by extension, the level of private debt in the economy is crucial to understanding it? How else do you explain the robust empirical link between private debt growth and indicators such as unemployment, housing prices and GDP?
Attempts to answer this framework should also avoid the standard circular tactic of assuming the money multiplier, then describing everything in terms of the money multiplier. But even when doing that, I just don’t see how you can square all the evidence with the exogenous money model. Prove me wrong.
Neoliberal economics – otherwise known as ‘free market economics’ or ‘The Washington Consensus’, appears to have doubled down recently, despite clear empirical failings. Mainstream debate has no shortage of economists preaching the virtues of deregulation, austerity and trickle down, and governments across the world seem to be listening. How did this happen? Probably somewhere between people’s refusal to abandon an entrenched ideology, the influence of the rich and powerful, and the lack of a sufficient alternative. In any case, here’s a series of facts that demonstrate quite how immune to evidence mainstream debate has become. I won’t offer much analysis here, just the neoliberal narrative of the crisis, contrasted with the facts, which I feel speak for themselves. This post is with a focus on the UK, but to some degree it applies to the US and Eurozone, too.
Firstly – the narrative goes – forget the ‘banking crisis’ – that’s over, now the real problem is the fiscal crisis:
Nevermind that debt is historically low, and that the market – which we praise for it’s ability to collect dispersed knowledge elsewhere – is saying that there isn’t a fiscal crisis:
In the UK, this invisible fiscal crisis is often pinned on the previous Labour government for spending too much in the boom years, long before the 2008 crash:
Note the fairly minimal deviations between taxes and spending prior to the crisis, during which, predictably, tax revenues fell and welfare spending shot up. Also note the refusal in the states to pin the deficit on Bush, whose pre-crisis policies actually did create a large chunk of the deficit. Anyway, I digress
Many on the right also claim that reported ‘debt’ is a red herring, and ‘off balance sheet’ obligations are far larger, for example future pensions:
I should note that this is with the Coalition’s pension reforms, but those reforms weren’t exactly revolutionary – just a bit of inflation reindexing and a few years of pay freezes. It’s pretty clear: at no point were pensions costs in any way a time bomb.
…despite the fact that the countries where it is often claimed we need deregulation, are lowest on the regulation index above. And no, there is no (inverse) correlation between regulation and growth.
They also claim we need to cut taxes, particularly on the rich or ‘job creators’:
The above is a graph from a study by Thomas Piketty, Emmanuel Saez & Stefanie Stantcheva, showing the lack of correlation between cuts in marginal tax rates and growth.
Finally, there’s the policy the right always have time for – austerity! Magically, they claim, it achieves all of our goals at once. Firstly, it helps us balance the budget:
The bottom line, fleshed out with a lot of evidence, is one that others — including me and Christy Romer — have been arguing for a while: expansionary fiscal policy under these conditions doesn’t just aid the economy in the short run, it may well even improve the long-run fiscal prospect. And austerity may be self-defeating even in fiscal terms.
and secondly, it boosts growth by allowing the private sector to fill the gap:
This paper investigates the short-term effects of fiscal consolidation on economic activity in OECD economies. We examine the historical record, including Budget Speeches and IMF documents, to identify changes in fiscal policy motivated by a desire to reduce the budget deficit and not by responding to prospective economic conditions. Using this new dataset, our estimates suggest fiscal consolidation has contractionary effects on private domestic demand and GDP.
Austerity for everyone!
This is part of the reason my blog is so abstract – the policy prescriptions of neoliberalism have survived despite being obviously wrong, so all that’s left is to attack the intellectual underpinnings. Whilst I’m aware that neoclassicism =/= neoliberalism, the latter relies on the former for a large part of its assertions about the effects of taxes, regulation and the labour market. If this intellectual justification disappears, neoliberalism will have little left to stand on.
It’s difficult for me to believe that people have internalised the ‘the government caused the crisis’ arguments, but sadly this is a view that many still cling to – with a healthy dose of wishful thinking, and often an unhealthy dose of concern trolling. I would ask the same people to list five examples they can think of where private enterprise failed significantly – if they can’t, it says a lot about their bias.
Let me note that for the purposes of this post, I am putting considerations over Central Banking failures to one side.
In essence, debates over whether the government ’caused’ the crisis are basically nonsensical and are mired in both Adam’s Fallacy and governments versus markets framing. Even if the government encouraged/incentivised homeownership and loans to the poor, the fact that banks exploited this by committing massive fraud is not the government’s fault. If you think it is, then we should logically blame limited liability laws for the crisis, since that was an example of the government ‘intervening’ to protect enterprise from predatory lending and encouraging start ups, and had the ‘unintended consequence’ of creating too much systemic risk.
However, even if we accept the framing, the facts simply don’t add up:
- For every $4 of bad loans, only $1 was issued by an institution covered by the CRA. Whether or not these loans themselves were a result of the CRA is debatable, as the penalty for not complying with it appeared to me little more than a slap on the wrist. An estimate by Fed economists for the amount of bad loans due to the CRA was about 6%. In fact, the case for the CRA causing the crisis is so weak that Barry Ritholtz has challenged anyone who thinks so to a debate, where the loser pays $100,000 to the winner.
- Fannie and Freddie are often painted as drivers of low income housing, but it’s quite clear that they follow the market and pick up the slack when private institutions experience trouble:
if you go further back, the only reason they had a large market share in the early 200s was from mopping up the S & L mess:
They did fail due to bad management, and they pushed standards as low as they feasibly could within their remit. But despite this, they were not at all involved in the worst of subprime.
- Regulations like Basel II and deposit guarantees are a last resort for government blamers, but the fact is that a single, completely unregulated hedge fund, Magnetar, accounted for between 45-60% of demand for subprime loans by pushing CDOs. The main source of funding during the run up to the crisis was also the repo market – again, completely unregulated. Neither Magnetar or the repo market had anything to do with Basel or deposit insurance.
Furthermore, countries like the UK, Iceland and Ireland, despite having no GSEs or CRA, experienced similarly severe crises, whilst those such as Germany and Sweden, with tighter regulation, did not. And even if it hadn’t been housing it simply would have been something else – banks have a history of creating crises out of whatever they can get their hands on, and the only common theme throughout them is a lack of regulation.
Whichever you paint it, it’s simply not credible to blame the government on a crisis that was clearly created by the private sector.
My main sources here are Michael W. Hudson’s The Monster: How a Gang of Predatory Lenders and Wall Street Bankers Fleeced America – and Spawned a Global Crisis and Yves Smith’s ECONNED
This post isn’t really intended as a comprehensive and rigorous critique of Austrian economics – I’ll leave that to others. Instead, it’s a brief summary of why I reject Austrianism (the brand most common on the internet, anyway*).
To start, I’ll take the liberty of quoting a commenter from Brad Delong’s blog, who summed up my overall impression of Rothbardians (and to a lesser extent, Miseans) pretty nicely:
The weird thing about Austrians, it seems to me, is that they don’t like empiricism, but they don’t seem to really like deriving any conclusions that they didn’t already know from their axioms either. The rejection of empiricism, along with claims like how empirical economists can’t explain people commuting on subways, are part of Mises’s though. Also, though, look at the case of Austrian rejection of modern microeconomics on the grounds that its use of utility functions and such is inconsistent with preference rank-based description of human choice-making. Basically, that’s a rejection of the Von Neumann-Morgenstern theorem as far as I can tell. (Even though Morgenstern may have been something of an Austrian himself.) I’ve never read an Austrian actually explicitly reject the theorem, or explain his view on it in any way, but the rejection seems to be implicit in their discussions of conventional, non-Austrian micro. Why reject Von Neumann-Morgenstern? As far as I can tell, because it doesn’t fit their conception of how economic analysis should be done.
So, if you don’t look at the world empirically, and you don’t want to extend your axioms to their logical implications to conclusions that you didn’t already know, what’s left? The axioms themselves, and some thoughts hanging around their immediate vicinity. Or, to put it another way, your initial prejudices. Your thought starts where it ends, exactly where you wanted it to.
That’s what I take from Austrian economics, at least.
Internet Austrians have declared capitalism to be infallible and as such are unable to blame anything on the private sector – their conclusion is always that it’s the state’s fault. I just can’t align myself with something that seems to come to the same policy conclusions, whatever the question, whatever the situation, whatever the starting point and methodology.
Another reason I find the Austrian school to be unsatisfactory is its failure to predict and explain the 2008 crisis.
As LK has documented, Austrian claims to ‘predict’ the crisis with anything like the accuracy of Michael Hudson or Steve Keen are spurious. At best, the Austrians spotted a housing bubble, no more. Furthermore, their theory doesn’t even appear to explain the crisis particularly well, for the following reasons:
Put simply, ABCT is based on a misallocation of investment in capital goods. The imbalances created by this result in a recession, which is necessary as the capital is liquidated and put to ‘proper’ usage elsewhere. But this isn’t what happened in the financial crisis; in the crisis people were simply buying and selling the same assets to each other – housing, mortgages and their derivatives – and most of the debt taken on went into consumption. Murray Rothbard himself said:
To the extent that the new money is loaned to consumers rather than businesses, the cycle effects discussed in this section do not occur.
Even if you accept that low interest rates caused the boom, the Austrian prescription of liquidation does not follow, as there was very little capital to ‘reallocate’. After all, derivatives are just contracts, an there is currently an undersupply of housing in many Western countries.
And, of course, sectors unrelated to the crisis have slumped at least as much as ones that were central:
On top of this, there is simply too much historical counter evidence against the idea that credit expansion/CBs cause business cycles. The Dutch Tulip Mania occurred under 100% reserve banking. The Melbourne Land Crisis occurred under a private gold standard system. The South Sea Bubble occurred without a Central Bank (The BoE did exist but was the same as the one we know and love only in name). Furthermore, the period of fewest crises was post-WW2, with universal Central Banking. This list is far, far from exhaustive.
Since this is a scattered post, I’ll also add that Austrians have completely failed to rebut Sraffa’s demolition job on Hayeks P&P (no, the response that there is schedule of interest rates does not qualify as it is simply restating the criticism), and also that their use of uncertainty appears not to recognise the term in the Knightian sense.
So, there you go. That’s why I’m not an Austrian.