Archive for the Category Great Recession

 
 

What the eurozone crisis teaches us about the subprime crisis

Consider the following:

Banks pour huge amounts of money into one particular asset class.  They are encouraged to do this by public policymakers, although there is some dispute about whether that was the main reason for their decisions.  These assets have a long tradition of doing well, although a close look at the evidence would have raised red flags.  The asset market in question suddenly takes a big dive as default risk increases sharply.  This drags down many large banks, forcing policymakers to provide assistance.

What have I just described?  The sub-prime fiasco or the PIGS sovereign debt fiasco?  I’d say both.  I’d say these two crises are essentially identical.  (I should clarify that by “essentially identical” I mean in essence, not in every detail.)

Of course the sub-prime crisis came first, so let’s consider the dominant (progressive) narrative of the sub-prime crisis.  If you read the mainstream media you will see it described as a sort of morality play; the evils of deregulation, which allowed the greedy big banks to take highly leveraged gambles with other people’s money, and then off-load the risk on to both taxpayers and unsuspecting buyers of MBSs.  Or something like that.

Obviously it would be impossible to tell a similar story for the sovereign debt crisis.  No regulator in his right mind would ever contemplate telling big banks not to buy European sovereign debt because it’s too risky.  Indeed the previous attempt at regulation (Basel II) encouraged banks to put funds into those “safe investments.”  Blaming the euro crisis on deregulation doesn’t even pass the laugh test.  The criminals were the regulators themselves.  Is the term ‘criminal’ hyperbole on my part?  Not at all.  Suppose Enron executives had used the same accounting techniques as the Greek government.  They’d all be in jail.  And as for Berlusconi, what can one say about a leader who continually passes laws exempting the Prime Minister from the very crimes he was accused of having committed?  As Keynes said:

Words ought to be a little wild, for they are the assaults of thoughts on the unthinking.

So here’s what I wonder.  Assume the eurozone crisis was obviously not caused by deregulation and greedy bankers.  Then if the sub-prime crisis was basically identical, at least in its essence, how can deregulation be the root cause of the former crisis?  I’m not saying it’s logically impossible, but doesn’t it seem much more likely that there’s a deeper systemic problem, which transcends this glib cliche?  I’m going to leave you with two very different items, which together seem to point to the flaws in our financial system being very deeply ingrained, far too deep to fix with any sort of politically plausible “reforms.”

The first is a heartfelt lament by Steve Waldman, from the recent Kauffman Foundation blogger’s conference.  Steve wonders why after all the outrage in late 2008, nothing fundamental has actually changed.  Even with Obama elected in 2008 and taking office along with a heavily Democratic Congress.

The other item is a very funny Jon Stewart routine (courtesy of Greg Mankiw.)   He shows that one of the progressive political figures who showed the greatest outrage, then left the government, set up his own investment company, used leverage even greater than Lehman Brothers, used political pull to fight off the regulators when they complained, and eventually drove his firm into a messy bankruptcy.

Why is all this so hard to change?  Why didn’t we just adopt the Canadian model, which never has these problems?  I don’t really know, but something tells me that the problems go much deeper than you might imagine when reading cliched morality tales about “deregulation.”

PS.  Of course you and I know that the real problem was (mostly) nominal; tight money turned medium size debt fiascoes into catastrophic financial crises.

How do we know that the problem is too little NGDP?

Ever since late 2008 I’ve been arguing that we misdiagnosed the crisis.  The main problem was not sub-prime mortgages and banking distress, but rather falling NGDP.  Indeed I’ve suggested that perhaps 2/3 of the banking crisis was due to falling NGDP expectations.

What about the other third?  That’s the obvious part—the subprime loans, the Greek debt, etc.  Now Matt Yglesias has a post that suggest 2/3rds may be an underestimate—we may rapidly be approaching a point where the global debt crisis is 75% or 80% NGDP shortfall:

Robin Wigglesworth covers capital markets for the FT and has a rundown of the ensuing carnage, which I shall summarize for you in bullet points:

“” Italian 10-year yields jumped 32 basis points to 7.02 per cent, which is the level that prompted Berlusconi’s ouster.
“” In Spain a new 12-month bond yielded 5.02 percent (up from 3.6) and 18-month yieled 5.15 percent (up from 3.8).
“” “France’s 10-year notes jumped 20 bps to yield 3.59 per cent – a record 188 basis points above comparable German Bunds.”
“” “The FTSE Eurofirst 300 index tumbled 1.5 per cent, led by the French, Italian and Spanish markets, and have now given up all of last Friday’s gains.”
“” “Belgium, Austria, and Finland’s 10-year benchmark bonds also widened markedly in early trading.”

Now Belgium and Finland aren’t really important countries in the scheme of things but this is a sign that you’ve moved into Total Chaos And Market Panic Mode. You don’t lose faith in Finland’s ability to repay debts based on shady budgeting in Greece or political dysfunction in Italy. You lose faith in Finland’s ability to repay debts when you wake up one day and realize that all European sovereigns no matter how well-run are in a third world fiscal position where they lack a lender of last resort.

It would be nice if the ECB became lender of last resort.  But even that isn’t really essential, and I’m not sure it would be enough.   What we really need is faster NGDP growth in the eurozone, even if the ECB does so by monetizing German debt.  Given the choice of boosting the NGDP growth rate by 5% while purchasing German debt, and acting as lender of last resort to Italy but sterilizing any effects on the monetary base, I’d take the higher NGDP growth.

The great irony of the Depression period is that by 1936 things had gotten so bad that even the French had to devalue.  The French had helped cause the Depression by their obsessive hoarding of gold, and their refusal to help out the weaker countries.  In other words, in monetary terms France was the Germany of the 1930s.  When you see doubts raised about countries like Finland and Austria, you really have to wonder if even the German debt is truly safe.

I still think the policy elite are slightly less pigheaded than in the 1930s, so I doubt things will go that far.  But it would be a lot simpler if they recognized reality right now, instead of dragging out the pain.

Three years ago I argued that falling NGDP was causing the debt crisis to get dramatically larger.  I’d be interesting in hearing whether you think that argument seems more plausible today, November 15, 2011, given the evidence provided by Matt Yglesias.  Or would you prefer to believe that the rising yields on Finnish and Austrian debt represents the market’s sudden realization that Finland and Austria are also run by corrupt governments?

Join the club

In late 2008 it was frustrating to hear all the triumphal statements from leftists about the failure of neoliberalism, the failure or of market fundamentalism, the failure of deregulation.  Of course the real problem was the tight money policy of the Fed, which caused NGDP to fall rapidly.

Now the progressives are getting a taste of their own medicine.  Just as the 2008 crash did look (at first glance) like a failure of capitalism, the 2011 euro collapse looks (at first glance) like a failure of the European big government welfare state model.  Here’s Paul Krugman fighting a losing battle:

What a tragedy. A rich, productive continent, which has produced arguably the most decent societies in human history, is tearing itself apart because its elite insisted on embarking on a dubious monetary project, and now can’t bring itself to take the steps necessary to give that project a chance of working.

He may be right about the virtues of Europe.  But take it from me, trying to sell that argument at a time like this is like trying to hold back the tide.

In reality, the US banking model was flawed.  It made no sense to deregulate the asset side of bank balance sheets as we were backstopping the liability side.  And in reality, the Greek and Italian and Irish governments made a lot of poor choices.  But capitalism works pretty well, as does the Northern European welfare state.  In both cases tight money made some very real problems seem much worse than they actually were.

The majority view will always be the common sense view.  When that view is wrong, there’s not much you can do except keep plugging away, and hopefully convince historians to re-write the history books a couple decades later (as Friedman and Schwartz overturned the original view of the Great Depression)  That original view was that the Great Depression represented a failure of capitalism.  Now it’s understood to be a failure of monetary policy.

Plus ca change . . .

Matt Yglesias on America’s self-induced paralysis

This is from an excellent Matt Yglesias post entitled “Could A Determined Central Bank Fail To Inflate?”:

He quotes both former Federal Reserve Vice Chair Donald Kohn and former NEC Chairman Larry Summers as expressing skepticism that it would be possible for the Federal Reserve to generate higher inflation expectations under conditions of depressed demand and slack output. It’s difficult for me to know how we would prove this one way or another, but I believe this view is mistaken. What’s more, I think it’s noteworthy that administration officials who say they believe this seem disinclined to follow this line of thought to its logical conclusion.

For starters, a little throat-clearing about the burden of proof. Many of the inflation skeptics have impressive resumes. What they don’t seem to have are empirical examples of central banks determined to raise inflation expectations and failing to do so. We don’t, unfortunately, have a directly parallel case to the current U.S. situation. But on my side I’ll cite as evidence the successful implementations of exchange rate policy by Sweden, Israel, and Switzerland during the current recession. Those, however, are small economy. So I’ll also cite FDR’s gold policy in the 1930s. That, however, was a gold standard. Then there’s QE 2. I would say we have examples of small open economies with determined policymakers doing this successfully. I would say we have an example of a large economy with determined policymakers doing this successfully under different historical conditions. And I would say we have an example of the Federal Reserving acting with only weak determination and achieving weak results. In my view that means our overwhelming presumption ought to be that a determined Federal Reserve system could increase nominal expectations, especially if the president and the treasury secretary supported that goal.

What’s more, it’s important to get a better understanding of why this would help the economy. The Obama administration seems to have thought of higher inflation expectations as useful primarily because they would help with the debt-deleveraging problem. That’s true. But there’s something more profound happening. Higher expected inflation lowers real interest rates and encourages investment. Higher expected inflation, at the margin, spurs consumption among households who aren’t debt-constrained. Most of all, higher expected inflation coordinates expectations so that households and firms expect higher levels of nominal spending and nominal income in the future, which encourages more real economic activity.

Now flip this around. What if I’m wrong. What if Michael Woodford and Paul Krugman and Lars Svensson and Scott Sumner are wrong? What if the academic writing of Christina Romer and Ben Bernanke is wrong? What if there’s something different about the 1930s and Switzerland and Sweden and Israel that means that in the United States you can’t spur higher inflation expectations as long as there’s all this slack in the economy? Well that’d be a pretty wild scenario. I first started to hear about this scenario back in late 2008 from folks who regarded themselves as well outside the mainstream of the economics profession. Their wacky idea was that faced with a deep recession, the government should basically just finance itself by printing money and not bother with the whole taxes thing. The natural counter to that argument was and is that such a policy would be highly inflationary. Personally, I’m old-fashioned, and I think it would be inflationary for the central bank to just print money at random to finance government operations. But by the same token, I have no doubt that a determined central bank can create inflation expectations. So bringing this back around to where we began, I think the Obama team made a huge mistake here and that most of the key players continue to be making the same mistake. Worse, a large fraction of the progressive community keeps making it along with them. But either the Fed could be doing a lot more to fix the economy, or else some really strange fiscal policy ideas need to be adopted.

It’s interesting to compare Matt’s post to the Ryan Avent quotation discussed in the previous post.  It seems to me that there is growing acceptance of this view among thoughtful centrists and progressives.  As much as I’d like to give credit to us market monetarists, there was obviously a sort of historical inevitability to the increased focus on the Fed, especially after fiscal policy seemed to reach a cul de sac.  Still, I think it’s fair to say we’ve at least contributed some talking points, which allow others to make the case much more effectively than we can.

PS.  I don’t mean to suggest that Avent and Yglesias are recent converts to these views–they been discussing monetary stimulus for several years.  Rather that the issue recently seems to have taken on a new urgency, especially given the lackluster employment numbers.

PPS.  This is also an excellent post.

Glasner demolishes Cole and Ohanian

Cole and Ohanian are right that the NIRA and other similar policies greatly retarded the recovery from the Depression.  So why do they have to push things too far, and try to suggest that demand stimulus didn’t play an important role?  David Glasner demolishes their argument in this post.  I’m really surprised they are still making these misleading claims.  I sent Ohanian papers with all the information in Glasner’s post, so I can’t see how they would be unaware that their data is extremely misleading.  At monthly frequencies wholesale prices and output were highly correlated throughout the Great Depression.  Period.  End of story.

I also keep pointing out that Paul Krugman continually misrepresents Lucas’s views of macro.  But he keeps doing it.   Lucas has indicated that the big drop in nominal spending in late 2008 and early 2009 depressed real output.  He does accept Friedman and Schwartz’s explanation of the Great Contraction.  But Krugman keeps implying Lucas believes demand shocks don’t matter.  Maybe Lucas doesn’t use Keynesian terminology, but he certainly buys the standard view that nominal shocks can matter in the short run, but not the long run.   BTW, I don’t agree with everything Lucas says about the Great Recession, but his views ought to be characterized accurately.

PS.  My email box keeps getting busier and busier.  Don’t be surprised if I’m not able to answer requests, or just give a one sentence explanation.  I encourage people to rely more on my previous posts, now that I am somewhat better organized.  The link at right called “Links to key blog posts and papers” is the place to go.  You need to scroll down on the right side of the blog to find that link, I’ll try to rearrange it later.  Eric Morey also recommended I put a link for RSS feeds for all comments, and I’ve done so in the same section.  I expect further improvements soon, and will let you know.

I’d also like to better organize posts by topic.  I spent 2 hours yesterday creating a new category; “China.”  There must be a better way.  I will gradually try to add more.