It is not true that “no one saw it coming”. There were, in fact, economists who predicted the financial crisis that led to the Great Recession and
1) cited an actual economic model in support of their argument, 2) pointed to the specific set of forces that really did lead to the crisis, and 3) got the timing right
but those economists were not followers of a mainstream school of economics thought so their findings fell on deaf ears. Those are the messages of John T. Harvey’s post at Forbes.
Unfortunately, a shortcoming of Dr. Harvey’s post is that he neglects to tell us who those economists were or how their views diverged from economic orthodoxy. It took a certain amount of detective work but I managed to figure it out.
Dirk Bezemer, the author cited by Dr. Harvey in his post, had a post of his own at the portal of the Center for Economic and Policy Research (CEPR), “‘No one saw this coming’ – or did they?”. As it turns out the economists who successfully predicted the crisis were proponents of something called the “flow of funds” macroeconomic model:
The model is solved by imposing macro accounting identities and adaptive expectations rather than individual optimisation. There is a steady state but not equilibrium. One advantage is that growth paths can be identified as unsustainable given the existing “bedrock†accounting relations. This allowed Godley and Wray in 2000 to conclude that “Goldilocks was doomed†– with a government surplus and current account deficit, US economic growth had to be predicated on ongoing and unsustainably high rates of private debt growth.
Here’s Dr. Bezemer’s summary of the flow of funds model:
In “Flow of Funds†models, liquidity generated in the financial sector flows to firms, households and the government as they borrow. This may facilitate fixed-capital investment and production, but it may also feed asset price inflation, consumption, and debt growth. Liquidity returns to the financial sector as financial investments or in payment of debt service and financial fees. Key features of “Flow of Funds†models are thus bank credit flows, since “evolving finance in the form of bank loans is required if production is to be financed …†(Godley, 1999:405). Also, there are explicit payment flows such as interest, “not quite the same as in the national accounts, where it is standard practice… to ignore interest payments, although they are an inevitable cost given that production takes time†(Godley, 1999:405).
If Carmelo Saleo’s assessment is correct, the flow of funds macroeconomic model may not be particularly helpful from a policy standpoint:
So maybe the bottom line is that the quantity theory of money is still a solid intellectual framework to think about monetary economics, and a good starting point to understand the general dynamics of money. But as a simple direct policy tool its best days might be already behind us (which, by the way, is no news to central bankers…).
Or, said another way, neither Neo-Classical, Keynesian, Neo-Keynesian, monetarist, nor the model that actually predicted the financial crisis provides any particular guidance.
I’m not sure I understand what “flow of funds” analysis was showing that anticipated the Great Recession. Is it that firms, households and the government were starting to borrow less, suggesting over-leveraged balance sheets?
What? Economics is useless in determining policy? Why, I never.
It was that keeping the party going required private borrowing at an impossibly high level and it also picked the time.
Maybe we’d all be better off following Ambrose Evans-Pritchard’s father:
Of course this means that blaming or crediting politicians for economic performance is even more nonsensical than many of us thought. If there is no ‘right’ answer easily available from the economics establishment, that seriously undercuts our politics-driven economic blame game. If your theory does not predict then it does not guide.
We’ve been running our entire country according to the mumbled incantations of alchemists and druids. We might as well just read the daily horoscope.
There are in my opinion some failures so revealing that they permanently destroy the credibility of an institution or ideology. The Roman Catholic failure to keep priests from raping children comes to mind. The CIA failing to notice the collapse of the USSR – the nation they were staring at 24/7. Economists managing to miss the biggest economic meltdown since the 30’s is another.
However, I’m sure if we clap real loud it will stand right back up again. Scientific sounding babble as a foundation to win votes, reward friends and punish enemies is always handy.
You’re going too far, Michael. Economics has two main branches: microeconomics and macroeconomics. Macroeconomics has substantial problems but many of the findings of microeconomics are solid and not even particularly controversial. Microeconomics tells us, for example, that under conditions of free trade both of the trading nations prosper because of comparative advantage. That’s a non-obvious but useful finding.
Microeconomics also tells us about the effects of rationing, taxes, and subsidies or how monopolies and cartels behave.
The majority of the members of Congress are probably poli sci majors. If instead of taking two of their poli sci classes they’d taken two econ courses, we’d all probably be better off. Being willfully ignorant is never defensible.
Economics is a social science like anthropology, psychology, or sociology. They’re descriptive sciences but that doesn’t mean that they’re useless.
Something else that may not be obvious: for every article, editorial, or post I comment on I probably read 10 that I never mention. One of them, for example, was a piece at RCP from Stephen Moore with the usual poppycock about tax cuts always paying for themselves. Why bother remarking? That’s a purely ideological position.
Purely ideological positions are flying fast and thick these days. The notion that all government spending is an investment, the underpinning idea for many people who favor a larger government, is just as complete nonsense as the beliefs of anarcho-capitalists.
The difference is that no one assumes we should base our political or life choices on anthropology or sociology. That’s the issue I have with economics. I love and support all human efforts to understand the universe, very much including economics. But economists have not been willing to say, look, we don’t really know, we’re still learning. They’re in the leeches and vicious bodily humours stage and claiming they can cure plague. And we all buy into it.
You just cannot miss the biggest economic event since the late 20’s and claim to know what you’re doing. If it suddenly turned out that there’s an Earth 2 hiding behind the moon, I think we’d all be giving astronomers the stinkeye. If the moonshot had missed the moon by a hundred thousand miles, we’d be raking mathematicians over the coals. Economics + Humility = No Problem. Economics + Arrogance = STFU. I have no tolerance for these priesthoods of the unready.
I hate to burst any bubbles, but credit fueled asset bubbles are as old as money and credit. Any credit or LBO oriented person could tell you that funds flow into consumption, productive assets or financial assets. I did for years here. So did Tasty. The hard part isn’t predicting the end result, it’s the timing, and that’s nearly impossible.
As for the economists, they aren’t blind. In an interview a Fed board governor flat out admitted that their strategy has been to create a wealth effect through asset inflation turned consumption. The problem is that you can’t guarantee consumption, it may be narrow consumption, you create a negative wealth (income, really) effect for holders of fixed income securities and none of that policy creates an incentive for business investment. For that you need fundamentals, not Fed manipulation.
I will tell you right now, with low mortgage rates and low loan to value requirements, plus demographic trends, real estate is in Bubble II. You only want to be in very select geographies, and you want to view home carrying costs as consumption. Your home is not an investment asset. The timing of the sell off? It has already started in many regions. I don’t think it will be a bang, but rather a slow slide.
Same for equities. Even though standard money manager speak is that equity valuations are “only at the high end of the range when adjusted for relative yield (dividend ratios to fixed income rates)” so don’t worry be happy, I’d expect a serious repricing. The timing? Who knows. And that brings us to fixed income securities. If rates are low, bond prices are high. Anyone got any ideas for what to do when rates begin to rise?
It may make oneself feel good to castigate the economists as dumb, but the fact is that they know all this. This was planned policy. The question is how to extricate the country from its crack high. They had hoped for fundamental recovery. However, There have been no policies out of Washington, and will be none out of a Clinton Administration, that address fundamentals. Just more of the same.
There’s an aspect of their strategy that I’m not convinced its proponents understand, Guarneri. We now import so much of what we consume that there is practically no multiplier. JIT inventories and modern warehouse management mean that retailers can accommodate just about any level of consumer demand without adding facilities or employment.
The only sector that’s really benefiting is the financial sector. Again, it’s a self-licking lollipop.
@Drew
… the fact is that they know all this. …
The policy makers, academics. regulators, politicians, economists, and any other expert was, is, and will most likely always be clueless (or at least late).
During a comment thread, somebody here pointed me to a link, and I think it was one of the @Zachriel. The link was a 2009 paper by somebody in the Fed or an academic person close to the Fed, and it was about this thing called “shadow banking”. It went how it worked, how it affected the housing boom through MBS’s, and how they should try to regulate this “thing”.
None of them have the foggiest idea of what the hell you do or why you do it. I may disagree with you about things, but the things @steve disagrees are not him misunderstanding an expert’s opinion. He faithfully reproduces their understanding of how things work.
They actually believe that anybody can walk into a bank and get a “liar’s loan”, and at first, they thought these loans were created specifically during the housing boom. (Since then, I think they have gotten a clue.) I tend to find the original sources, and I learn from people who actually have some knowledge of their field and some field experience. My big mistake is that I assume these experts actually know what they are supposed to know.
Their understanding of how the world works is about the same as a third grader’s idea, and they are supposed to be experts. If they were only voicing their opinions, it would not be so bad, but their proscriptions are actually enacted.