Causes of the Crisis

Critical Review has started a new blog “Causes of the Crisis” featuring contributors to the journal’s stellar issue on the topic. The papers in CRs special issue add up to the best and most comprehensive autopsy of the financial collapse available anywhere. The blog looks terrific too. Some excerpts…

David Colander:

Using models within economics or within any other social science, is especially treacherous. That’s because social science involves a higher degree of complexity than the natural sciences. The reason why social science is so complex is that the basic unit in social science, which economists call agents, are strategic, whereas the basic unit of the natural sciences are not. Economics can be thought of the physics with strategic atoms, who keep trying to foil any efforts to understand them and bring them under control. Strategic agents complicate modeling enormously; they make it impossible to have a perfect model since they increase the number of calculations one would have to make in order to solve the model beyond the calculations the fastest computer one can hypothesize could process in a finite amount of time.

[…]

This recognition that the economy is complex is not a new discovery. Earlier economists, such as John Stuart Mill, recognized the economy’s complexity and were very modest in their claims about the usefulness of their models. They carefully presented their models as aids to a broader informed common sense. They built this modesty into their policy advice and told policy makers that the most we can expect from models is half-truths. To make sure that they did not claim too much for their scientific models, they divided the field of economics into two branches—one a scientific branch, which worked on formal models, and the other political economy, which was the branch of economics that addressed policy. Political economy was seen as an art which did not have the backing of science, but instead relied on the insights from models developed in the scientific branch supplemented by educated common sense to guide policy prescriptions.

In the early 1900s that two-part division broke down, and economists became a bit less modest in their claims for models, and more aggressive in their application of models directly to policy questions. The two branches were merged, and the result was a tragedy for both the science of economics and for the applied policy branch of economics.

Vernon Smith:

Hayek made a similar charge [to Krugman’s in his long NYT piece] in his Nobel Lecture of December 11, 1974, The Pretence of Knowledge:

… the economists are at this moment called upon to say how to extricate the free world from the serious threat of accelerating inflation which, it must be admitted, has been brought about by policies which the majority of economists recommended and even urged governments to pursue. We have indeed at the moment little cause for pride: as a profession we have made a mess of things.

Although Hayek saw the problem as stemming from an inappropriate “scientistic” attitude, he explicitly wanted “…to avoid giving the impression that I generally reject the mathematical method in economics.” Rather, his main message was that

If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible…The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men’s fatal striving to control society – a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.

Economic scientists have precious little understanding of this rule governed complex order, and how to keep it on its demonstrated long term path of growth and human betterment without suffering too irreparably from the kind of unpredictable reverses that we are now mired in. Less pretence and a commitment to learn from the new data being generated as I write, will be both humbling and informative, after the inevitable human political impulse to blame one’s long standing political adversaries has run its course.

I look forward to posts from the other contributors.

Ezra Klein on Consumption, Debt, and Inequality

Ezra and I chatted a bit on Bloggingheads about the ideas in his post replying to a bit of my paper, but I had yet to read the post, my response was off-the-cuff, and I think I can do better.

So, I noted in my paper that nominal consumption inequality has increased much less than income inequality (and I go on to argue that real consumption inequality may have dropped). Ezra says:

You’d think the fact that our ears are still ringing from the deafening “pop!” of the consumption bubble would, in some way, impact this analysis. But it doesn’t. Nor does the word “debt.” But that’s how many households have kept their consumption high amid widespread wage stagnation.

Megan McArdle posted an excellent reply, for which I am grateful:

I think it’s easy to overstate the contribution of debt, for two reasons.  First, many of the discussions on consumption equality focus on the poor, who were still relatively credit constrained even at the height of the bubble.  And second, income inequality figures exclude both taxes and government benefits.  Things like the EITC and Section 8 vouchers really have made a quite substantial improvement in the ability of the poor to consume.

So I don’t think we actually know how much of a difference consumer credit made to equalizing consumption between rich and poor.  I suspect that the continued mechanization of formerly labor-intensive tasks has made a greater difference, but then you’d expect me to say that.  The data we want will not be available for several years, especially since period immediately following the financial crisis will be very atypical*, and therefore not useful in assessing the longer term trend.

Let me add that I don’t think pre-recession wage stagnation has been exactly widespread. It has been suprisingly focused on low-skill, male workers. Also, to be exactish, money wages can stagnate or fall while total compensation rises. And total labor-market compensation can stagnate or fall while total disposable income, including government transfers, increases. (Additionally, income from “informal” markets tends to be under-reported, but likely shows up in consumption surveys.) So, as Megan points out, a steady level of consumption for a household with stagnant wages (and no savings) needn’t imply increasing debt. That said, I suspect many lower-income households have over recent years increased their level of debt, and I suspect that this has played some small role in keeping consumption inequality in check. But we shouldn’t infer from the bust following the boom that this was mostly “bad” debt. I think improved access to formal credit markets has been a net plus for lower-income households. And even if some of this increase in debt took the form of sub-prime mortgages, not all of that turned out bad.

More to the point, the economy tanked due to a burst housing bubble. I agree that there was, in some relatively clear sense, overconsumption of houses–a good generally bought on credit. The reasons for this are many, but first among them is that the government, in many ways, rather encouraged house-buying. The economy-wide delusion about the long-term trend of housing prices seems to have been both a cause and effect of the bubble, as well as a cause of highly unrealistic individual/household estimates of wealth that could safely be borrowed against now. So, yeah, lots of people who wrongly thought they were house-rich ran up their credit cards. I think it’s safe to say that there was “too much” debt-financed consumption. But I would hazard to guess that, on the whole, this would tend to widen rather than narrow the income and consumption gaps. As I note in my latest column for The Week:

“High-income households are highly exposed to aggregate booms and busts,” report Northwestern University economists Jonathan A. Parker and Annette Vissing-Jorgensen in a recent National Bureau of Economic Research working paper. They estimate that our current bust is hitting the income and consumption of households in the top 20 percent of income earners significantly harder than the households in the 80 percent below. And the higher up the distribution you go, the harder the hit is likely to be.

That incomes at the top are now so sensitive to aggregate consumption (it didn’t use to be that way, Parker and VIssing-Jorgensen say) would seem to at least partly explain the coincidence of very high average debt-levels and high levels of inequality that Ezra emphasizes later in his post.

Folks were running up their credit cards because they thought they were house-rich. They thought they were house-rich because they were in the middle of a housing boom that made the current and future value of their houses look a lot higher than they really were. Those with compensation schemes highly sensitive to changes in aggregate demand–high income households–saw a disproportionate rise in already high income as consumption boomed. So income inquality went up. And now they same households have likely seen a rapid drop as consumption has fallen off a cliff. So income inequality went down. At least that’s part of the story. And it remains conjectural until the relevant stats finally roll it. (Also, I think it remains that the primary cause of rising income inequality has been the rise in returns to human capital investment [pdf], and that hasn’t gone anywhere.)

So, I think Ezra is probably right to suspect some kind of correlation between high levels of income inequality and high levels of average indebtedness. Both levels partially reflect the housing-bubble-driven boom in consumption. But I don’t think it would be right to imply (as Ezra seems to in his post) that the high level of inequality somehow independently contributed to the crash.

How the Promise of Future Subsidies Can Freeze Markets

I think Casey Mulligan nails it:

The [Chicago city] council has debated mandating hybrid purchases. But the rumor among taxi drivers is that in addition, or perhaps instead, the city or other government agency will eventually subsidize the purchase of a hybrid.

Drivers have decided that they should not purchase a Prius or other hybrid until the subsidy arrived. Buying one now would mean over-paying.

Regardless of whether it is realistic to expect Chicago to someday subsidize purchases of hybrid taxis, the fact is that some cab drivers are considering the possibility. If taxi drivers consider future subsidies in their industry, then so must bank executives.

Last fall the public learned that banks were not selling many of their legacy mortgages and mortgage-backed securities, despite the impression that ownership of the assets were hindering the banks’ lending. A variety of theories have been put forward to explain this failure, and to suggest what the government might do to fix it.

But the lack of trade in mortgage-backed securities may have something in common with the lack of trade in hybrid Chicago taxicabs. The secondary market for legacy mortgages may have stagnated largely because of the (ultimately correct) anticipation of a huge government subsidy.

Taleb's Ten Principles

To prevent future crashes. I think most of these are pretty good. Explanations for each principle in Taleb’s FT piece

1. What is fragile should break early while it is still small.

2. No socialisation of losses and privatisation of gains.

3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus.

4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks.

5. Counter-balance complexity with simplicity.

6. Do not give children sticks of dynamite, even if they come with a warning 

7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”.

8. Do not give an addict more drugs if he has withdrawal pains.

9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement.

10. Make an omelette with the broken eggs.

Dani Rodrik on Simon Johnson

Of Johnson’s widely cited and highly regarded Atlantic piece, Rodrik writes:

Simon’s account is based on a very simple, and I believe misguided, theory of politics and economics.  It is an odd marriage of populist and technocratic visions.  Countries fail because political elites always end up in bed with economic elites.  The solution, apparently, is to let the technocrats (read the IMF) run your affairs.

On the whole, I think I side more strongly with Rodrik than Johnson. (I find it hard to have a firm opinion in these matters.) That said, perhaps it’s “populist” to think political elites always end up in bed with economic elites, but it seems, as a matter of fact, they often do. My opinion is that a certain “populist” enthusiasm for democracy, in the absence of strong legal and cultural constraints on government action, almost inevitably delivers a great deal of regulatory capture–that is, tucks political elites snugly in bed with corporate elites. Isn’t that a cynical vision? Moreover, when the incentives of insufficiently-limited democracies lead to this kind of result, supra-national technocratic institutions can in fact act as a salutary check on governments precisely because they are undemocratic.

Free Exchange’s Washington blogger seems to have something like this in mind:

Of course, the IMF can’t hold America’s feet to the fire in the way that the WTO can. But the WTO achieved that power, in part, because American leaders wanted an outside force to be able to tie their hands, so they could shrug at angry voters and say, “Sorry, them’s the rules”. I wouldn’t be surprised to see national leaders constrained in crisis response by domestic politics seeking to empower the IMF in the near term.

That’s a really interesting thought. Now, I am not, and have never been, the biggest fan of the IMF and Rodrik is right that it’s weird for Johnson to talk about the Fund as if everyone knows all about its totally awesome track record. That’s just a little too convenient for Johnson, an old IMF hand. Nevertheless, it’s not crazy to look for a disciplining force external to national democratic politics when the interest group dynamics of national democratic politics has helped create the problem and persist in blocking the solution.

Galbraith: Listen to Galbraith or the Economy Gets It!

James K. Galbraith’s Washington Monthly piece “No Return to Normal” is a mix of the completely sensible (propping up bad banks is a recipe for further looting by insiders and more stupid risk-taking) and a totally crazy conviction that modern states are economically magical institutions. That is, it is a James K. Galbraith piece. Here is some crazy:

Apart from cash—protected by deposit insurance and now desperately being conserved—the American middle class finds today that its major source of wealth is the implicit value of Social Security and Medicare—illiquid and intangible but real and inalienable in a way that home and equity values are not. And so it will remain, as long as future benefits are not cut.

Yes, 401(k)s are down, and Galbraith’s thesis seems to be that they always will be unless… guess what? But, okay, suppose he’s right and there is no recovery if we fail to embrace James K. Galbraithianism. In what crazy world does the economy both (a) fail to recover and (b) the government make good on already completely infeasible entitlement commitments? And how bizarre is it to say in the space of two sentences that a source of wealth is “real and inalienable” just as long as benefits are not cut through the democratic process — which of course they can be and probably must be if Galbraith is right about the likelihood of a no-recovery future. If voters can lose some portion of future government transfers by voting for politicians who vote them away, then those transfers are obviously alienable. (The courts clearly say there is no legal right whatsoever to these transfers.) And alienable future transfers from the government that are conditional on political will and economic feasibility are about as “real” as my future lovechild with Gisele Bundchen. Does anyone have an interpretation of Galbraith’s passage that makes sense?

He later goes on to claim, amazingly, that increasing spending on Social Security is “an economic recovery ace in the hole.” So the best I can do is guess that Galbraith is incoherently shuffling back and forth from a scenario in which we don’t use his “ace in the hole” (investments and home values worthless forever!) and one in which we do (Social Security checks good as gold.) But that’s hardly fair, is it? 

A main theme of Galbraith’s article is that things are so bad that mainstream economics can be of no assistance, so you’ve got to go heterodox. But he says nothing to clarify why, if we must abandon the consensus views of professional economics, one should prefer Galbraithianism over other departures from othodoxy. He seems to infer his own views from the alleged failure of standard views. It is rather gentle to note that that doesn’t follow. For example:

In short, if we are in a true collapse of finance, our models will not serve. It is then appropriate to reach back, past the postwar years, to the experience of the Great Depression. And this can only be done by qualitative and historical analysis. Our modern numerical models just don’t capture the key feature of that crisis—which is, precisely, the collapse of the financial system.

I largely agree about the inapplicability of many models, but it’s not at all obvious that the experience of the Great Depression is more rather than less applicable than those models. The Depression was a long time ago. The economy was a lot different then. If one is going to do “qualitative and historical analysis” then it seems that recent collpases in the financial systems of other countries are rather more germane. Why not look at those instead of reaching back “past the postwar years”? Because there’s some ineffable but essential Americanness to the American economy? Galbraith actually seems to think so, which is why one must look away from the examples of Argentina and Indonesia! This seems arbitrary and I don’t get it. Of course, if we go back to the Great Depression, we just become mired in competing “qualitative and historical” analyses, which in reality tends to sound a lot like “Must destroy Amity Shlaes!!!” And that’s obviously a lot more intellectually rigorous and helpful than stupid mainstream economists with their stupid mainstream models.

The Opportunity Cost of the Bailouts

Richard Florida offers some insight

The bailouts and stimulus, while they may help at the margins, also pose an enormous opportunity costs.  One the one hand, they impede necessary and long-deferred economic adjustments. The auto and auto-related industries suffer from massive over-capacity and must shrink.  The housing bubble not only helped spur the financial crisis, it also produced an enormous mis-allocation of resources. Housing prices must come a lot further down before we can reset the economy – and consumer demand – for a new round of growth. The financial and banking sector grew massively bloated – in terms of employment, share of GDP and wages, as the detailed research of NYU’s Thomas Phillipon has shown – and likewise have to come back to earth.

On the other hand,  there is the classic question: What better and more effective things might have been done with these trillions?  That’s for historians to ponder and decide. But the combination of the massively misallocated resources produced by the bubble (plus the costs of military adventures)  combined with humongous bailout spending puts the US behind the economic eight-ball in a way it has not been in more than the century. Having hold on the reserve currency helps, but it cannot absolve all these compounded sins.  Sooner or later the money will run out; bills will come due.

That creates a wide open structural opportunity to accelerate what Fareed Zakaria has dubbed the “rise of the rest” to accelerate.  Crises are periods where the relative position of nations and regions can and do  change dramatically.   (Do I think the US will lose its hegemonic position: Of course not.  My hunch is that the US is in the same position structurally as England at the onset of the Long Depression of 1873.  It was not until the next major crisis – the Great Depression of 1929 and the onset of WWII that it lost its position  [to] the United States. So worst case: The US has one more long-cycle at the top of the heap).   But, just think of all the ways the trillions of bailout money could be used to build the economy of the future. And while you’re doing that imagine that some other places … that have been patiently building and conserving their resources may start to figure out how to do just that.

I don’t give a fig about the U.S.’s relative position, but I do care about the absolute level of welfare and thus the absolute level of innovation and it is here that I worry about the costs of American decline.