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June 10, 2012

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foosion

>>Instead, the problem was that the losses caused by the bursting of the US housing bubble were concentrated among a few organization who - we now know - were unable to bear them. Had the losses been more dispersed - as the tech burst's losses in 2000-03 were - the macro effects would have been much less nasty.>>
The housing bubble was a case with a small number of lenders and a large number of borrowers. It hit many homeowners and people in housing related industries.

The tech bubble was a case with many more investors and many fewer in related industries.

>>I have this suspicion that the nature of macroeconomics - with its emphasis upon mathematical tractability rather than complexity - is influenced more by what can be safely inflicted upon students than by what best describes the real world.>>

A frequent claim is that the RBC types love elegant math and don't care about empirical evidence (how well theory describes the real world), while the Keynesians insist on evidence even if theory isn't as neat.

RedShift

>>However, a bit of me is less sympathetic. I have this suspicion that the nature of macroeconomics - with its emphasis upon mathematical tractability rather than complexity - is influenced more by what can be safely inflicted upon students than by what best describes the real world.>>

So you don't think that these theories were developed primarily with the aim of "proving" that free markets work, that fiscal stimulus is ineffective, and business cycles are simply optimal responses of the system to technological shocks, so governments shouldn't try to smooth them?

I don't think the corruption of the economics profession has been looked at enough. Many of the big banks and corporations were paying economists to say everything was rosy in the garden. The film Inside Job did a great expose of the economics profession; for example, Frederick Mishkin wrote a piece praising Iceland's financial system, having been paid by their banks to produce the report.

And I wonder if, before answering what's wrong with economics, can anyone say what's right with it? Stanislaw Ulam once asked Samuelson to name one theory in all of the social sciences which is both true and nontrivial. Samuelson responded with Ricardo's trade theory, however his theory isn't true because trade doesn't really work like that. Has economics genuinely come up with a theory that satisfies Ulam's two criteria?

chris

@ Redshift - yes, some economists were in the pay of banks, but very many weren't.
Ulam's question highlights another failing of economics, but not in the way he or you intend. For me, economics is not about grand theories, but rather about identifying mechanisms. The search for big theories is something else that's led many economists astray.

Andrew

Chris, this is total nonsense. Non-sequitur patrol again:

"If high debt were the main culprit, you'd expect defaults and bad debts to have risen before the recession. They did, but not by much. In late 2007, the delinquency rate on US household mortgages was less than a percentage point above its mid-90s level. The biggest rise came after Lehmans collapsed."

It simply does not follow that defaults have to rise much for an evidently unsustainable bubble to collapse. Once DEMAND for such securitized debt collapses (and it did) then the game is up.

High debt, much of it fraudulent, relative to carrying capacity was of course the main culprit. Debt has been increasing faster than GDP for decades. The US housing bubble and many other debt piles around the globe was unsupportable and this became clear. You only had to look at the interest rate increases looming on the option-ARM mortgages. You didn't have to wait for the actual defaults (which were probably being kept hidden by the fraudulent institutions in any case).


Andrew

I think this might however be the prize nonsense:

"Instead, the problem was that the losses caused by the bursting of the US housing bubble were concentrated among a few organization who - we now know - were unable to bear them. Had the losses been more dispersed - as the tech burst's losses in 2000-03 were - the macro effects would have been much less nasty."

Concentrated among a few institutions?! So a near 5 trillion dollar loss of asset value has no effect on the home owning population of the US then? All of whom would of course have been heavily invested in the tech bubble!

Left&rational

If you take a look at any recent issue of the Journal of Monetary Economics (I guess the flagship macro journal) I think you will find it anything but mathematically tractable.

It would be nice if undergraduate teaching and research at the frontier could be better synthesised, but there are many reasons why this is not easy. (by the way @redshift this is not to say undergrad programmes at any uni I know of are designed to reinforce some 'neoliberal' conspiracy.)

Andrew

And what about central banks?

How do we expect markets to operate when interest rates are suppressed, large institutions have implicit government backing and no one believes the the Fed will let house prices or stocks collapse?

Guido Fawkes

Different approach, same theme, you are not the only one who thinks the banking crisis stems from a failure of ownership structures:

http://order-order.com/2011/11/06/moral-markets-and-other-peoples-money/

TheOldBrewer

The problem is clearly linked to ownership. Too few very large organisations placing very large bets with each other. I guess that many trading strategies would have been sound if adopted by thousands and thousands of individuals placing very modest bets. Many of these strategies probably do not work on an industrial level.

The other problem is the need to pool the deposits of thousands and thousands of risk averse retail depositors.

Therein lies a paradox. Arguably because there hasn't been transparency many institutions have lost touch with the beneficial owners of capital put at risk.

Trevor Brown

If prediction were possible (surely the whole point of 'economics'?) - life would as we know and love it would be impossible.

http://fabooks.wordpress.com/2009/09/02/hope-filled-economists-and-the-hopelessness-of-economic-forecasting/

chris

@ Andrew - I never said a fall in house prices would have no effect. One reasonable estimate says the wealth effect of the fall in US prices in 05-09 should have reduced consumer spending by 2.4%, cet par:
http://cowles.econ.yale.edu/P/cd/d17b/d1784.pdf
This gives us a moderate recession, offsetable by orthodox and modest fisca/monetary policy. To get the crisis we've got, something else must have happened. That something is that banks were ill-equipped to bear the effects of the fall. In this sense, it was banks that went wtrong, not (so much) households.

Stephane Genilloud

Maybe you should rephrase the question: what's the worst mistake of economics?
Because, obviously there are many serious flaws in this discipline (and this why non-economists have an easy time coming with non-relevant criticisms, such as the rationality one of your previous post). I can think of two substantial flaws:

Economists spent too much time discussing the efficiency of free markets, and they completely missed the side effects of the system. Individual competition induces a loss of collective purpose and a decline of probity. It's not typical of the economy, it is typical of competition. Read some of Michael Lewis' writings for some convincing examples (http://www.vanityfair.com/business/features/2010/10/greeks-bearing-bonds-201010).

Economists are not aware of their responsibility. When the euro was being designed, in the 90's, there was probably a majority of economists who considered it was mistake (but probably not to the extent of what we are experiencing at the moment). Some wrote some academic papers, others just discussed the issue at the cafeteria with colleagues. There gave very little warning and did not speak out in mainstream newspapers or on TV. And now we have a failure that makes the Titanic look like a laboratory experiment, and whose fault is it? The politicians who did not want to listen, or the economists who did not make themselves heard?

This said, Stumbling & Mumbling is possibly the only blog that, beyond economics, discusses its purpose.

RedShift

>>by the way @redshift this is not to say undergrad programmes at any uni I know of are designed to reinforce some 'neoliberal' conspiracy.)http://www.econ.cam.ac.uk/silvaplana/papers/meon.pdf

http://www.economicsnetwork.ac.uk/iree/v8n1/bartlett.pdf

http://www.standupeconomist.com/blog/are-economists-selfish-a-lit-review/

Left&rational

Interesting references but these findings are at best very modest in comparison to your thesis.

Reference 1 is not published. But assuming that its findings are affirmed by peer review, then what are we to make of it? Should voluntary transactions be encouraged or discouraged? Perhaps your own ideology leans towards authoritarianism, but you must admit its track record is not impressive.

Reference 2 documents an interesting correlation but does not establish that studying economics causes political orientation. I don't know what grade you got in your econometrics course but you should be clear on the distinction between correlation and causation.

Reference 3 Is at best very qualified. In Bauman's own words there is NO indoctrination effect for econ majors. This contradicts rather than supports your argument.


Left&rational

I might add that it's also somewhat ironic that you cite papers from academic economics to support your argument against academic economics.

Luis Enrique

the dominant practise in macroeconomics was to assume shocks hit the economy and then ask what to do about them. Cutting edge models had multiple sources of shocks, heterogenous agents, a variety of frictions and so forth, all of which could be thought of as taking the models closer to reality.

what they weren't doing is asking where the shocks come from and how to prevent them, which ex-post is what everybody now thinks they ought to have been doing - we didn't want them just to use models in which a massive shock occasionally hits the financial sector, for example, we wanted them to see those shocks coming and prevent them

so my answer to this question - if the question is what's wrong with short-run macroeconomics as opposed to economics in general - is that the methodology doesn't really make it easy to study what goes wrong in economies, dysfunctional behaviour and so forth and to think about what causes recessions, as opposed to how to react to them. And of course complacency about financial markets was perhaps the most important instance of that.

Chris I think you are right the financial crisis was really a micro problem - to really predict its specific form, macroeconomists would have to have been keeping track of the contents of bank balances sheet, contingent liabilities and all.

As it happens, economists who actually study finance had plenty of models of dysfunction, fragility and so forth. But for some reason these economists were largely ignored.

Some macroeconomists did study financial crises (say Eichengreen) but these guys were international macro people, who look at currency crises, flows of hot money, sudden stops etc. and tended to swim in different waters from mainstream short-run macro.

[oh yes, and the average economists is to the right of Redshift, let's agree on that and say no more about it]

Bros

Brown: "If prediction were possible (surely the whole point of 'economics'?) "

Absolutely not, it is not the job of economists to try and predict the future or forecast crisis, see here: http://www.voxeu.org/index.php?q=node/3996

Genilloud: "Economists spent too much time discussing the efficiency of free markets"

I think this is an urban myth; most of the efficiency properties of markets was outlined before world war 2, most of the papers since then have been trying to explain completely different phenomenon, or exploring when markets fail.

Keith

The real failure here is surely that all the "innovations" in finance, now a word to be understood as deeply ironic, were directed at building up the return from capital in the financial sector of the economy. The increasing share of profits in this one sector as a proportion of the total was unsustainable but no one really believed that enough to stop it. The more successful this effort seemed the less incentive any one had to ask questions about it, setting up the fall. The greed is good assumption underlying economics produces this sort of thing repeatedly over time. More "risk" equals more gain. The firms that take the most "risk" acquire more power in the market and in terms of political lobbying power. Hence they weaken regulation. When the fall happens they take down far more than would have been possible before. So this seems to me a failure of the assumptions underlying economics and political theory. The Countervailing forces supposed to exist in the economy or political system are illusory or too weak to stop a build up of private irresponsible power. That arises from an unwillingness to see accumulated private wealth and the profit motive as a destabilising force and a threat. Which a traditional left wing or social democratic political economy does do.

Andrew

@Chris

"@ Andrew - I never said a fall in house prices would have no effect. One reasonable estimate says the wealth effect of the fall in US prices in 05-09 should have reduced consumer spending by 2.4%, cet par:
http://cowles.econ.yale.edu/P/cd/d17b/d1784.pdf
This gives us a moderate recession, offsetable by orthodox and modest fisca/monetary policy. To get the crisis we've got, something else must have happened. That something is that banks were ill-equipped to bear the effects of the fall. In this sense, it was banks that went wtrong, not (so much) households."

The banks were wrong because of the households and the households went wrong because of the banks. It's a credit bubble after all.

If you are so interested in mechanisms, why do you only consider negative wealth effect on consumer spending? What about all the others - arrest of construction spending, destruction of small business confidence and hiring, stock market declines, smothering of price signals by policy response, etc etc?

The reasonable estimate of consumer spending decline you quote is in the middle of a range of 0.9% to 5.4%. And these figures may not actually reflect consumer behaviour over the crisis.

Of course the banking system was at the heart of this credit bubble.
The financial system was levered up 30:1 or more, and the bubble asset decline made it instantly insolvent. That is virtually a tautology.

I'm sure you're familiar with Reinhart and Rogoff's study suggesting that recoveries from financial crises are more protracted than inventory driven recessions. They always have large unemployment increases, a large housing and stock price declines. In other words a widespread and broad-based destruction of wealth, complete with confusion and doubt regarding the value of investment for the future.

For you to suggest, against such a backdrop, that the key problem was concentration of losses in a few institutions seems bizarre.

Can you outline this concentration problem as it affected the financial crises covered by the Reinhart and Rogoff study?

It would seem to me that a wipeout or near-wipeout of the financial system's capital base would create a crisis regardless of the initial distribution of those losses.

Andrew

@Chris

Non-sequitur patrol: "Nor is it obvious that the bursting of the housing bubble was to blame. US prices fell 10% between April 2006 and late 2007 whilst the economy continued to grow."

Is there any link between those two sentences?

Luis Enrique

Although some economists were on the credit cycle thing already, for example

http://www.newyorkfed.org/research/epr/10v16n1/1008gean.pdf

And maybe a focus on predicting shocks wouldn't be so useful, on second thoughts. People have been predicting a current account crisis type crisis for years that hasn't happened. I suppose the most basic predictor of crises is debt levels, see here

http://www.nber.org/papers/w15512

But once we've established that, then what?

(and Steve Keen, someoby who,I think spirits crap 99% of the time, gets big credit for pointing to that)

Andrew

@Luis. Yes indeed, how about looking at debt levels!

What economists don't seem to understand is that the real complaint from intelligent individuals is not the lack of a specific prediction. It is the lack of identification of danger and the lack of humility when it comes to policy recommendations.

Andrew

I find it hilarious that economists who defend themselves by saying that they are not in the business of prediction are usually all in favour of central banks setting interest rates.

Left&rational

@Andrew,

Non-sequitur alert.

How is that institutional preferences are related to prediction (or it's absence)?

Bros

"It is the lack of identification of danger and the lack of humility when it comes to policy recommendations."

Then I don't think you've read any economics papers. Economists are always extremely explicit with the assumptions they are using, the predictive power of the model and to what extent it holds true and which factors need to remain constant for it to do so. It's extremely rare a paper would ever outright advocate any policy; in 99% of cases the only thing they advocate is further research.

Main Street Muse

"I say this because the crisis was, to a large extent, due to the failure of a handful of organizations. It was/is a banking crisis, not a financial crisis - and, I'd add, a failure of ownership structures rather than of markets."

@ Chris - to speak of a "handful of organizations" is a sly way to define the failure of the entire US financial sector. I don't know how you can look at the crash and think it the result of that tiny "handful" of organizations.

The entire financial sector was put on life support. It required trillions of dollars in federal support - making our financial sector one of the largest recipients of federal welfare. As a result of the crash and the federal aid that followed, the smaller banks became frailer and other TBTF insitutions became much more consolidated and even bigger. Four years after the crash, our financial sector remains rickety and weak.

Real estate is a market, not just an handful of "ownership structures." You may not want to recognize this, but the failure of the real estate market in many parts of the US is a significant market failure, one that impacted any number of other markets and other business entities (builders, moving companies, relo experts, corporations interested in relocating talent, but tripped up by the terrible housing market, etc and so on).

We also had a situation where the person who went before congress to declare the economic state of emergency was a man who just two years before had been running Goldman Sachs - and just four years prior to that, he had gone before congress to argue the need to lower capital requirements for banks like GS, etc. And today, the head of JP Morgan Chase sits on the Fed's board. Both of these situations pose extraordinary conflicts of interest that no economic model can properly reflect.

You also state: "Nor is it obvious that the bursting of the housing bubble was to blame. US prices fell 10% between April 2006 and late 2007 whilst the economy continued to grow."

The recession began in late 2007 (http://cnnmon.ie/LBDB6V). How can an economy grow in a recession? Please provide a source for that statement. And how much have prices fallen since April 2006? The fall of home prices did not stop with the start of the recession - it looks like we may have just reached the bottom - in 2012, SIX YEARS after prices began their fall. And what about the impact of the highest foreclosure rate in decades? Why do you consider those factors irrelevant?

The profession of economics is lively, not boring - yet today it is a profession in crisis. To whine about the "irritation" that "non-economists" (like myself) provide when they question the economics field is not what your profession needs right now.

What I would ask you and other economists - if macroeconomic models cannot truly reflect the complexity of the modern economy - if they can be used to prop up reprehensible business practices that send our economy over a cliff, what is their purpose?

A better question for you: how can economic models be better designed so as to help us better manage the complexities of modern markets? The irritating complaints of "non-economists" should be irrelevant when your field is faced with such questions.

Antidismal.blogspot.com

I the big thing you are missing is the role of government in creating the environment and incentives which drove much of what happened. As John Taylor has argued, interest rates where "too low for too long", there is the role of Fanny and Freddie in the housing market, the moral hazard problems of the bank bailouts and so on. Much of this had more to do with politics than economics.

DerekMorison

The best mathematical model for the 2008 crash is to imagine the banks as a dozen cyclists roped together. As long as everyone keeps pedalling at the same speed and in the same direction everything's fine. But as soon as one puts on the brakes or tries to alter course...CRASH!
The bursting of the housing bubble needn't have led to a crash if everyone had kept their nerve. Negative equity doesn't automatically lead to default; most folks would be happy to keep paying the mortgage and keep a roof over their heads. It was the spiralling interest rates on uncapped mortgage products imposed by a few panicky cyclists near the front that precipitated a cascade of defaults.

Bros

"if macroeconomic models cannot truly reflect the complexity of the modern economy - if they can be used to prop up reprehensible business practices that send our economy over a cliff, what is their purpose?"

No macroeconomic model is comprehensive, but they can be useful in isolation in analysing specific aspects of the economy. On the other hand, combining lots of different models from macro, financial and other sub-fields as well as atheoretical econometric studies will give you a decent understanding of the economy.

Bros

Of course, assuming you're aware of the structure and history of the economy too (which is also studied, economic history is a good subject with a lot of useful research).

Main Street Muse

@Bros: "On the other hand, combining lots of different models from macro, financial and other sub-fields as well as atheoretical econometric studies will give you a decent understanding of the economy."

Can you explain to me (and I am admittedly one of those "non-economists with lots of questions), how no one seemed to have a "decent understanding of the economy" until it crashed? Signs were there - but ignored; this I do not understand at all, given the magnitude of the crash. [Prior to the crash the workings and thought processes of economists were things I cared very little about.)

Bros

@Main Street Muse: No-one is a hyperbole, I think plenty had a fairly decent understanding, although the ones worried about a financial collapse in particular (Shiller, Baker, Stiglitz, Miller etc..) perhaps weren't in a position of power.

One thing to note is that most economists are not macroeconomists, most specialize in other fields such as development, economic history, behavioural etc... Of the macroeconomists and financial economists, they rely on accurate data, a major problem is that banks were not properly disclosing information. I'm sure if the balance sheets of all the banks were properly known to economists and were reported accurately rather than with dodgy accounting and dodgier non-opaque securities in which it's difficult for anyone to properly understand (including PhD physicist quants etc..), it could have helped prevent a crisis if caught early enough.

The housing bubble itself was non controversial, it was being openly discussed among economists; bubbles come up frequently in the literature. What wasn't well understood is what Chris refers to, the institutional structure of banks which was highly problematic but is also extremely complex and difficult for anyone to understand. Sure there were rants and rumours circulating around financiers and hedge fund managers of some crazy stuff going on, but the raw data was not easily available or too messy to publish on. Finance became so complex and non-transparent that almost nobody, not just economists, understood exactly what was going on. That was the problem; however numerous papers being published now I think explain quite well what happened, I think the crisis has caused a huge amount of research to develop into modern finance, such that a 'decent' understanding now exists (I never said it was always there specifically with respect to high finance, reality is always changing, a decent understanding 15 years ago may not be a decent understanding now given the constant evolution in finance).

Left&rational

Bros is right. A very large amount of the relevant information was hidden, at least at a systemic level. E.g. We now know that leverage ratios were absurdly high, but for many reasons (off-balance sheet reporting, and misclassification of 'safe assets') this just wasn't visible.

It's not academic economics that is the problem, rather something, or a set of things more specific. I do think we should take a good look at the credit ratings agencies (not the only problem, but certainly a nerve point). These organisations specifically assess risk - you could call this forecasting or predicting without too much of a stretch. For various reasons, including the above, they got this very wrong.

But what theses people do, and what academic economists do are quite different. Academic economists are academics. We are slow and reflective. Most of my colleagues are very humble indeed, perhaps too much so. Papers cannot be published without extensive caveats describing how the research results cannot be generalised. This seems to be the opposite of the public perception, but that is how it is.

They want us 'screaming from the rooftops' on the one hand, but to acknowledge the limitations of our models on the other. It is difficult to square this circle.

BT

@ Chris. "It's not just the housing bubble bursting".

Household debt:GDP is one bubble. But financial sector debt:GDP is another large one. Both ratios are coming down in the west.

Steve Keen says it is the accelleration of credit/debt that matters most for growth, so house prices don't need to actually fall for the brakes to be applied to mortgage borrowing and for the economy to slump.

Roger Gathman

This fundamentally misunderstands the housing bubble as simply a price problem. The housing bubble was a two dimensional problem.One was the rise of housing prices. The other, however, was the use of a variety of new, unregulated instruments to pull "value" out of houses. These instruments - particularly the use of second mortgages to "monetize" home equity - peaked in 2006, at some trillion dollars. To not understand this flow of money into the economy, and how it essentially functioned as the Fed and the Bush administration's way out of the 2001 slump,is not to understand the housing bubble. According to this nice forbes article, 'home mortgage debt outstanding was 73 percent of the GDP" last year.
"That's the third-highest reading on record, after the 75%-plus bubble years of 2006 and 2007."
http://money.cnn.com/2009/05/27/news/mortgage.overhang.fortune/index.htm

In the 90s, it was 46 percent. The housing bubble was, in large part, a private debt bubble, which made up for the refusal of the government, in 2001, to run up a large enough debt to get the economy going. It is that simple.

Main Street Muse

To Bros & Left&Rational,

Thank you very much for your cogent and helpful replies. Much more informative than a rant against the uninformed.

One of the things I keep reading (and Alan Greenspan was a huge shill for this concept) is that markets are "rational." I really hope a key takeaway for economists who are developing models and analyzing the current markets - markets are led by irrational beings who withhold key information precisely to distort market conditions.

And when the market heats up and starts acting with "irrational exuberance" - economists - the quiet thinkers - need to take a closer look into the reasons for such "irrationality." And they need to stop being so quiet and perhaps start chattering loudly about potential market distortions that could wreck the economy once again.

I think the reason the "non-economists" are angry with economists is that you are viewed as people who do have the knowledge and training to help prevent such a crash. I hope economists view themselves as that as well. A nation at the mercy of quants and unethical bankers is not part of the traditional view of America....

Christiaan Hofman

Really, the biggest problem with macro is that it has been ideologized by some. Quite a few macro economists keep on repeating zombie lies (yes, they're lies) long after they've been conclusively been discredited by natural experiments, just because these ideas correspond to their ideology. That is a big sin for any scientist, but even more so for a scientist who studies a subject of real relevance to the lives of many people.

Left&rational

Well my own take (I'm not sure how representative of the profession as a whole this is) is that most of what happened can be rationalised.

Greed was the motive, and the regulatory framework didn't prevent this from morphing into theft, for want of a better word.

I'd put non-rational modes of behaviour pretty low down the list of candidate explanations.

As for pre-emotive diagnosis I'm afraid I'm going to have to repeat one point already made. This really isn't easy, especially when the data are corrupt and incomplete. We don't have the knowledge you might hope we have, and training is a poor substitute for bad data.

And to this I would again repeat that academic discourse is slow, and necessarily slow. Establishing new findings is akin to establishing 'proof' in courts of law. Peer review is slow. Scientific doubt is our method, and this just doesn't fit with loud chatter.

You need another fall guy.

Luis Enrique

Left&rational

yes, it's been said that homo economicus is a psychopath who would steal, lie, whatever, to raise his own consumption. Which is pretty much how a large set of people think of bankers. Making it harder to understand objections to the assumption of this variety of 'rationality' in the context of modelling the financial sector.

Carmen Basilovecchio

What's wrong with economics?
http://stumblingandmumbling.typepad.com/stumbling_and_mumbling/2012/06/whats-wrong-with-economics.html
Justaluckyfool (Google) has an answer.
"Anyone who attempts to predict the future is a fool; if by chance correctly than they are just a lucky fool, albeit always a fool.
Economists are just like stock gurus.They are fools who are believed because they were lucky. They take probabilities from the past and present them for the future.
They all have a change of luck over time.
A broken clock is correct twice a day, so who are you following?
check out www.justaluckyfool.wordpress.com

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