Ó The Economics Profession Asleep at the Switch ONE OF THE BIGGEST PUZZLES about the failure to anticipate the financial crisis is the lack of foresight of so many academic economists..
Trang 1Ó
The Economics Profession
Asleep at the Switch
ONE OF THE BIGGEST PUZZLES about the failure to anticipate the financial crisis is the lack
of foresight of so many academic economists There were exceptions; Nouriel Roubini was only the most emphatic of the Cassandras Raghuram Rajan issued strong warnings in 2005, Paul Krugman in the summer of 2007, Martin Feldstein that fall I mentioned Robert Shiller The collapse
of Bear Stearns in March 2008 elicited warnings
from other economists, such as Alan Blinder and Lawrence Summers—the latter of whom, however,
had sarcastically dismissed Rajan’s warnings three years earlier as “leaden-eyed.” But as far as I know, only Roubini among prominent academic econo- mists forecast an actual depression Warnings
about recession do not attract much attention, and
perhaps should not The standard response to a
Trang 2re-The Economics Profession Asleep at the Switch
cession is for the Federal Reserve to lower interest
rates That is what it did in response to the mild post-g/11 recession —thus setting the stage for the credit binge that has precipitated a depression Macroeconomics and financial economics are highly prestigious fields of economics, and the leading macroeconomists and finance theorists are brilliant people Yet although the housing bubble started to leak air in 2005 and burst in 2006 and the economy was in recession from the end of 2007
at the latest and the drumbeat of signals warning
of an impending crash became deafening by the spring of 2008, not enough economists, whether in
academia, the government, or business, sounded
the alarm in time to have a significant impact on the government or the banking industry Securiti- zation of mortgages and other debts was taken at face value as protecting us against the kind of housing-credit bubbles that had ravished East Asian countries in the 1ggos In May 2006, Federal Reserve chairman Bernanke said that the housing market was “cooling,” but that this cooling was “or-
derly and moderate” and that the market appeared
to be “headed for a safe landing.” His predecessor, Alan Greenspan, who in July 2005 had expressed mild concern about housing prices, said in Octo-
Trang 3ber 2006 that the “worst may well be over.” Public officials cannot be expected to be completely can- did at all times But the statements by Greenspan and Bernanke that I have quoted in this book were misleading; they made things worse
In September 2007, Robert Lucas said that he was “skeptical” that the subprime mortgage crisis would “contaminate the whole mortgage market” and cause the economy to slip into recession On October 1 of that year John Cochrane denied that there was a recession and predicted at worst a mild recession In testimony before Congress in Febru-
ary 2008, a month before the Bear Stearns crisis,
John Taylor advised against the Federal Reserve’s reducing interest rates In a speech in May, he said that interest rates were too low He had been right years earlier when he had said they were too low, but the time when they should have been higher
was long gone; to raise interest rates in a depression
tember 23 Allan Meltzer opposed any government
Trang 4The Economics Profession Asleep at the Switch
intervention, opining that the failure of Lehman Brothers had been inconsequential and that “Main Street” was doing just fine Robert Hall was unwill- ing on October 10 to state that a recession had be-
gun; one month later, Hall described the evidence
that the nation was in recession as “conclusive.” All
these are prominent macroeconomists
I attribute such errors of prediction not to ob- tuseness but to disbelief that the country could be
sliding into anything worse than another of the mild
recessions that we had had intermittently since the end of World War II Many other leading macro- economists, and prominent finance theorists as well, were simply silent as the storm gathered and broke; perhaps that was the prudent course Even now, the profession seems adrift in uncertainty and irres- olution, as if it cannot believe what has happened
No consensus has emerged with regard to how best to respond to the depression Most economists seem willing to try virtually anything in an effort to dig the economy out of the hole into which it’s fallen
Alan Greenspan, the chairman of the Federal Reserve from 1987 to 2006, was an economist held
in high regard by the economics profession In con-
cert with Robert Rubin and Lawrence Summers,
Trang 5successive Secretaries of the Treasury between
1995 and 2001, Greenspan pushed through and ex- ecuted the policies that set the stage for the depres- sion The triumvirs refused to restrain lending, ei- ther by raising interest rates or by tightening the regulation of banks’ capital structures; to bring the new financial instruments under regulation; or to prick asset-price bubbles, as the Federal Reserve could have been done (and eventually did—too late) by raising interest rates Bernanke, a brilliant academic economist, succeeded Greenspan and continued his policies Both missed the warning signs, and Bernanke, who became chairman of the Federal Reserve in 2006 and before then was chair- man of the President’s Council of Economic Ad- visers, was slow to accept that there would be no soft landing and that the Federal Reserve would have to trundle out its most powerful artillery to stop the slide Had the Federal Reserve acted sooner, the bubbles would have burst with less force and the depression would probably have been averted; and likewise if it had reacted strongly when the col- lapse of Bear Stearns gave clear warning of a com- ing disaster But I have acknowledged that there are political problems with pricking asset-price bub-
bles, and the Federal Reserve cannot maintain its
Trang 6The Economics Profession Asleep at the Switch
or connected the decline in personal savings to the danger that such lending posed to the economy Not enough seem to have realized that the crisis of the banking industry, when it hit, was a crisis not of (or at least not mainly of) illiquidity but of insol-
vency Not only were warning signs ignored until
too late, but when the economics profession finally woke up we learned that neither government econ- omists like Bernanke nor private economists had prepared any contingency plans for dealing with a depression It should have been reasonably clear that a 20 percent or more drop in housing prices would endanger bank solvency; that such a decline
in housing prices against the background of a prob- able housing bubble was not out of the question; and therefore that measures to strengthen the banks’ balance sheets, as by increasing reserve re- quirements, would be prudent Greenspan and Ru- bin have now apologized for their lack of foresight
Trang 7and preparedness, which is to their credit but does not enhance public confidence in the govern- ment’s management of the economy; and lack of confidence is one of the things that cause people to hunker down in periods of economic distress by reining in their spending
Some of the media commentary has attributed the economics profession’s unsatisfactory perfor- mance to academics’ being overly reliant on ab- stract mathematical models of the economy But academic economists are not the only macro-
economists of note; Greenspan was not an aca-
demic before becoming chairman of the Federal Reserve He was a consultant, and a former presi- dent of the National Association of Business Econ- omists And professors of finance, who are found mainly in business schools rather than in econom- ics departments, and whose field overlaps macro-
economics in regard to recessions and depressions,
tend to be deeply involved in the real world of financial markets They are not only armchair the- oreticians; they are consultants, investors, and
sometimes money managers; many of them, either
before joining a university faculty or during leaves
of absence from the university, have worked for the Federal Reserve, the International Monetary Fund,
Trang 8The Economics Profession Asleep at the Switch
or other nonacademic institutions Their students typically have worked in business for several years before starting business school and so bring with them up-to-date knowledge of business practices The entwinement of finance professors with the financial industry has a dark side If they criticize the industry and suggest tighter regulation, they may become black sheep and_ lose lucrative consultantships This conflict of interest may have caused some economists to pull their punches More important, few theorists spend their time poring over or digging behind banks’ balance sheets Busi- ness economists—consultants, and employees of business firms or trade associations— emphasize economic forecasting, and often have industry-spe- cific knowledge and data, but many are compro- mised by their business status One does not expect
economists employed by real estate companies or
by banks to be talking about housing and credit bubbles
Insofar as the depression can be attributed to
mistakes by Greenspan, Bernanke, Summers, Ru-
bin, Paulson, and Cox (the last three not econo-
mists, however), the mistakes may be due in part
to an overinvestment by economists, policymakers, and business leaders in a free-market ideology that
Trang 9opposes aggressive governmental interventions in
the operations of the economy Not all the econo- mists who believe strongly in the robustness of mar- kets and are skeptical about regulation are “con- servative” across the board—economists can be liberal in the sense of being egalitarian and favor- ing redistributive policies without wanting to regulate corporate practices How to make the economic pie as large as possible is a different ques- tion from whether to slice it differently The point
is only that excessive deregulation of the financial industry was a government failure abetted by the political and ideological commitments of main- stream economists, who overlooked the possibility that the financial markets seemed robust because regulation had prevented previous financial crises The depression is a failure of capitalism, or more precisely of a certain kind of capitalism (“laissez-
faire” in a loose sense, “American” versus “Euro-
pean” in a popular sense), and of capitalism’s big- gest boosters
At the root of the profession’s failure to anticipate and respond decisively to the depression is the fact that the study of depressions is a rather unsatisfac- tory branch of economics Not that it is neglected
by economists, the way economists nowadays ne-
Trang 10The Economics Profession Asleep at the Switch
predicted that one reaction to an economic crisis
would be a decision by a number of high-income people, widely imitated by other high-income peo- ple, to forgo conspicuous consumption that they could well afford?
Another problem with depression economics is
that depressions are rare events in the life of most nations, so that to assemble a sufficiently large sam- ple to be able to draw reliable statistical inferences that would illuminate the causes, gravity, con- sequences, and cures of depressions requires pool- ing data on depressions in different eras and differ- ent countries and thus in different, often radically
different, institutional, cultural, political, and eco-
Trang 11nomic environments In so heterogeneous a sam- ple each data point is likely to be idiosyncratic There are too many differences between America
in the 1930s and Japan in the 1990s (or even be- tween America and Japan in the 1930s, when Ja- pan’s depression was very mild compared to ours)
to allow a confident inference that deficit spend-
ing, which failed to cure the Japanese depression
of the 1990s, would likewise have failed to restore our prosperity even if implemented consistently dur- ing the depression of the 1930s A further but typi- cal complication is that while the reduction in fed- eral government spending in 1937, coupled with
a tightening of bank credit, is generally agreed to have caused the “second depression,” which lasted almost until the United States entered World War
II (as late as 1940 our unemployment rate was 15
percent), the effects of these simultaneous changes
in policy cannot readily be distinguished Still an- other complication is that the second depression may have been due in part to New Deal measures that restricted output, such as the National Indus- trial Recovery Act and National Labor Rela- tions Act
I mentioned Hitler’s Germany as an example of swift recovery from the Great Depression Heavy
Trang 12The Economics Profession Asleep at the Switch
deficit spending on limited-access highways (the famous Autobahnen) and on combat aircraft, sub- marines, tanks, and other munitions, coupled with
conscription, eliminated unemployment years be- fore the unemployment rate in the United States dropped below 15 percent A similar rearmament program in Japan had similar effects Our enor- mous deficit spending to finance the war against the Axis corresponded to Germany’s and Japan’s re- armament spending —in all three cases military ex- penditures financed by borrowing appear to have been effective depression cures So here are three anecdotes to support Keynes —and notice how they also support his argument that public spending can
be an effective depression antidote even if it is oth- erwise worthless He gave the example of hiring the unemployed to dig ditches and, having done
so, to fill them up again Military expenditures re-
semble the ditch-digging example (or my example
of feral-cat shelters) in making no contribution to
economic welfare in the usual sense But the anec- dotes provide only limited guidance for the United States in the present depression because the cir- cumstances are so different The power of Keynes’s theory lies in its simple, commonsense logic: if the
private demand for goods and services falls, so that