Economists and the crisis

There has been some discussion on why (and not whether) economists missed seeing the crisis coming. I came across this report but I thought most points were already covered in popular discourse/debate on the failure of models, reliance on one single metric of risk (VaR), etc.

But, for the sake of completeness, here is the link to this report from the Kiel Institute for the World Economy.

Thanks to Prof. Dani Rodrik, I came across an article by Prof. Barry Eichengreen in ‘National Interest’. Written boldly, it makes several simple and forthright points. Here is a sample:

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.

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.

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. [Read the full stuff here]

He points to the rising importance and popularity of empirical research (inductive economics, as he calls it) as a reason to end the article on a note of hope about economists’ ability to warn of and help to avoid the next crisis. Well, I am not so sure. But, it is good to hope for good things.

Policy decoupling if not economic decoupling

Professor Arvind Subramanian at Harvard wrote this piece a month ago. But, thanks to a visit to Prof. Dani Rodrik’s blog, I chanced upon this only today. I am not so sanguine about the absence of backlash against market-economics in the developing world. But, I must concede that the chance that he speaks to more policymakers across the world than I do is far greater.

He makes some interesting points in the article. Made a mental note to get hold of the paper by Devesh Kapur that he mentions. Read the full stuff here.

Krugman – Ferguson Slugfe(a)st – Final Part

The dessert – the Fed chairman

 The Gold Standard (TGS) does not believe that history repeats itself exactly, much less, economic history. So, TGS won’t bet on Japan’s deflationary outcome being repeated in the U.S. even though in many other respects, the US has taken many leaves out of Japan’s book.

That said, premature paeans are being composed in honour of the current Federal Reserve Chairman. In his article in the FT, NF says,

Credit for averting a second Great Depression should principally go to Fed chairman Ben Bernanke

He comes close on the heels of David Ignatius at Washington Post who calls the Fed chairman a quiet tiger and seeks his reappointment for another term, already.

H…mmm, TGS feels that the crisis remains a work-in-progress or process and that judgements are premature.

Krugman – Ferguson Slugfe(a)st – Part 4

Extra serving: the battle continues in Op-Eds

 It may be a digression but Gold Standard (TGS) must record here the profound distaste he felt when he first read the ‘triumphalist’ Chimerica piece by NF and a co-author. It appeared to have been written in the early part of 2007 but appeared in a journal in December 2007. It turned out to be spectacularly wrong.

 He did an exercise in revisionism (only partially) in September 2008 and earlier this year. See here and here. Note that he takes a swipe at other ‘panglossian economists’ who thought that Chimerica would endure for ever. But, he pointedly excludes himself. If you read his original piece, you would think that he was being less than scrupulous in excluding himself from the ‘Chimerica’ cheerleading gang.

 Unfortunately, the battle did not end there, as we noted earlier. Moreover, it has continued in their respective Op-Eds.

 Paul Krugman wrote in his Op-Ed on May 28, 2009 that the only thing we have to fear is inflation fear itself.

 He seemingly makes a persuasive point here:

Is there a risk that we’ll have inflation after the economy recovers? That’s the claim of those who look at projections that federal debt may rise to more than 100 percent of G.D.P. and say that America will eventually have to inflate away that debt — that is, drive up prices so that the real value of the debt is reduced.

Such things have happened in the past. For example, France ultimately inflated away much of the debt it incurred while fighting World War I.

But more modern examples are lacking. Over the past two decades, Belgium, Canada and, of course, Japan have all gone through episodes when debt exceeded 100 percent of G.D.P. And the United States itself emerged from World War II with debt exceeding 120 percent of G.D.P. In none of these cases did governments resort to inflation to resolve their problems.

What PK conveniently fails to mention is that in all these ‘modern’ examples including that of his own country, the overall national debt (public and private sector) were far more modest than what the US boasts of now. Every one splurged on debt. That is the difference.

He says that it was hard to escape the conclusion that inflation fear-mongering was partly political, although he waves a white flag (sort of) towards fellow economists who might disagree with him.

Inquiring minds want to know if he thinks that Federal Reserve Chairman and members of the FOMC were indulging in inflation fear-mongering.

Both the OECD and the Michigan consumer surveys in the US point to rising inflation expectations among the US public. That started to happen well before ‘inflation fear-mongering from politicians’ and pundits.

He should also note that crude oil had its best month in May and retail gasoline price inflation would now be turning significantly positive on a YoY basis. The base effect of falling gasoline price is now over. Retail gasoline has come up more than 70% from its recent floor.

 Not to be cowed down, NF has fired his salvo again in today’s FT. Clearly, his ego has been piqued. The first part of the Op-Ed is consumed by his pique. The second half of his post is more substantive. The key sentence is this:

The policy mistake has already been made – to adopt the fiscal policy of a world war to fight a recession.

That is indeed worth debating. In fact, I would debate both the fiscal and the monetary policy responses. In the end, we may come away with the conclusion that it was all worth it. But, no conscious debate has taken place and no costs have been identified and chalked up against these efforts. It is inconceivable that there won’t be costs. It is important to know what they are and on whom would they be apportioned globally.

Krugman – Ferguson Slugfe(a)st – Part 3

Main course 2 – joint serving by both

What is interesting is that PK himself provides a possible angle.

The only thing that might drive up interest rates—and this is a real concern (emphasis mine) – is that people may grow dubious about the financial solvency of governments.

NF was quick to latch on to that:

Well, if you listened carefully to what Paul Krugman said, he actually agreed with me. Because what he said was that everything is just fine as long as the financial credibility of the United States isn’t called into question, but my point is that it will be called into question

That should have been end of story. In some sense, PK prolonged it and ended up throwing gratuitous insults at NF with Bradford providing support. It is all unsavoury stuff and rather needless. Each one is talking past the other and taking ideological stance because somewhere towards the end NF manages to squander all his advantage.

It is important to reproduce what NF said, in entirety, on the topic of State vs. Market:

Well, I tell you what, I feel depressed after what I’ve heard tonight. We are now contemplating a massive expansion of the state to substitute for the private sector because that’s the only thing Paul thinks will deliver growth. We’re going to reregulate the markets, we’re going to go back to those good old days. Where were you in the 1970s when all these wonderful regulations were in place? I don’t remember that going too smoothly. But what else are we going to do? We’re going to print money. Almost limitlessly we’ll print money. That’s going to be fine, too. And when we’re done with that, we’re going to raise taxes. What a fabulous package we have in store for us. You know, back in late 2007, I was asked what my big concern was, and I said, “My concern is that we’re going to get the 1970s for fear of the 1930s.” It’s very easy to forget, in your iron indignation at the failure of the market, where the true mainsprings of economic growth lie. The lesson of economic history is very clear. Economic growth does not come from state-led infrastructure investment. It comes from technological innovation and gains in productivity and these things come from the private sector, not from the state.

 No one in their right minds would disagree that innovations, by and large, comes from the private sector (sometimes they come from research done in State-funded universities on which the private sector free rides. That is a different story).  But, who has now brought the State into play? His favourite private sector. In fact, the State went out of the way to be friendly to the private financial sector. This is how they chose to reciprocate: by bequeathing to the world the worst financial crisis since the Great Depression (that is until now; they may well go on to claim the top slot eventually).

Moreover, official statistics shows that investment spending is declining in his home country and in his adopted country. What is the alternative to fiscal stimulus, if growth matters?

So, if PK responded ideologically, NF vindicates him with his ideological response without acknowledging the cause of the crisis and without providing any real alternative.

Krugman-Ferguson Slugfe(a)st – Part 2

Main Course 1 – served by Niall Ferguson

Here is where you can find the transcript of the panel discussion.

This is what NF said in that panel discussion:

There is a clear contradiction between these two policies, and we’re trying to have it both ways. You can’t be a monetarist and a Keynesian simultaneously—at least I can’t see how you can, because if the aim of the monetarist policy is to keep interest rates down, to keep liquidity high, the effect of the Keynesian policy must be to drive interest rates up.

But, I can see that Niall Ferguson did not make such a bloomer. Perhaps, he skipped a few steps in the middle.

The burden of PK’s song is this: When there is ‘incipient excess savings’, fiscal spending does not ‘crowd out’ private investment, it is essential and it is not contractionary via higher interest rates?

What happens if fiscal stimulus raises inflation expectations – whether theory says so, or not? Of course, Krugman would say, ‘Inflation expectations can rise only if the economy were operating close to or at or above potential and that if inflation expectations rise, it would mean that people would start spending and that means no excess savings. Only then, would NF be proven correct. We are a long way off from that.’

The point is that regardless of whether there is excess saving with me or not, if I choose not to lend to some one, the interest rate the borrower has to offer to attract funding either from me or any one else, has to go up. My reluctance can stem from any of the following: lack of trust, lack of credibility, irrational fear of inflation, etc.

After all, no matter what PK’s diagrams say, if at the Treasury auction, bidders demand higher coupons because of perceived risks (default, inflation, etc.), then that is the reality. Isn’t it?

In other words, when we throw in expectations, confidence and risk premium, that NF could not be so wrong. His mistake was that he did not elaborate his first point.

Let us also recall what Mr. Bernanke told the Congress on May 5th:

Inflation expectations, as measured by various household and business surveys, appear to have remained relatively stable, which should limit further declines in inflation.

Furthermore, this is what the FOMC Minutes tell us:

Some participants highlighted the potential pitfalls of making inflation projections based on contemporaneously available measures of resource slack, especially during periods when the economy was facing large supply shocks and significant sectoral reallocation.

Krugman – Ferguson Slugfe(a)st – Part 1

The appetizer – ‘Crowding out’

It all started with Krugman (PK) posting this on his blog. He sighs, expresses exasperation with Niall Ferguson’s ‘ignorance’ and alludes to some ‘dark age of macro-economics’. Strong stuff. Link here.

In fact, there is some history to this. PK, perhaps, was having this at the back of his mind when he reacted strongly to Niall Ferguson (NF). By the way, this is not justification for Paul’s reaction but an explanation.

In a downturn, characterised by waning or weak animal spirits in the private sector, non-government investment spending does not happen to the extent that savings exist. In fact, the gap between the two widens (i.e., savings > investment). So, the talk of ‘crowding out’ (of private investment by public investment) here engaged in by Fama and Cochrane (that PK criticises) is ideological warfare. The Gold Standard (TGS) sides with PK on this issue in the current circumstances in the US.

 ‘Crowding out’ happens when government wades in with its own deficit spending in a pro-cyclical manner – something that Government of India did between 2006 and 2008.

So, that is not the issue here. The issue is whether government spending and borrowing could cause interest rates to climb when there is excess saving. In theory, when there is excess saving, cost of borrowing remains low. It cannot rise. But, theory and reality are two different things.

 In fact, if one goes through the transcript of the roundtable that took place between Niall Ferguson, PK, George Soros and others, it is clear that PK himself provides an answer to this question. Yet, he went ahead and posted an exasperated comment on his blog. He supplemented it here and here.

 Somewhat pompously, he even outsourced further comments on the topic to Bradford de Long – some mutual backs-scratching, of course. Now, that was too long an appetizer. Let us serve the main course now.