Overtrading, Revulsion, and Discredit 2007-‐2010 J. Bradford DeLong U.C. Berkeley and NBER March 2010
This Talk • Five parts: – – – – –
Where are we? How did we get here? Where are we going? What should we do about it? How will history evaluate us?
• Accompanied by parentheQcal comments about the state of economics as a discipline: – I confess I was somewhat shocked when I realized that the economic theory I needed... was preTy much all developed before 1850... – That says something depressing about claims to be a progressive and progressing discipline...
Where We Are: Worst Recession since 1938
How Did We Get Here?: Economists’ Hubris • Four Qmes in the past century and a half prominent economists have assured us that: – “The central problem of depression-‐prevenQon has been solved” —Robert Lucas... – Earlier we had: • Walter Heller: “new dimensions of poliQcal economy”... • Irving Fisher: “permanent and high plateau”... • Walter Bagehot: the Bank of England knows how to manage Lombard Street...
• When a prominent economist says that the problem of depression-‐prevenQon has been solved... • ...hold on to your wallet!
How Did We Get Here?: The PaTern since 1825 • John Stuart Mill in 1844:
– A commercial crisis is the recoil of prices aber they have been raised by speculaQon... set in moQon by something which affords apparent grounds for expecQng... extra demand.... The rise... aTracts new speculators... The largest purchases are oben made at the highest price. But at last it is discovered that the rise has gone beyond the permanent cause... Then the recoil comes.... Many... contracted engagements which they trusted to a further rise for giving them the means of fulfilling... [I]n 1825 and at several other periods in the present century... the ulQmate revulsion is most extensive and calamitous... – As long as the seasons vary, as markets fluctuate, and men miscalculate, or the passion of gain... over-‐rides their calculaQons, so long will these alteraQons of ebb and flow, these “cycles,” as Colonel Torrens has named them, “of excitement and depression” [will] conQnue. They are worse in America than in England because American commerce is conducted in a more gambling spirit...
We Should Have Been ExpecQng This • 1990: The S&L crisis and its credit crunch:
– Deposit insurance coupled with mis-‐regulaQon... – Heads we win, tails the government loses... – Remember the “KeaQng Five”?
• 1998: The East Asian crash:
– Hot money from abroad... – Poor regulatory framework... – Heads we win, tails it’s the foreigners’ problem...
• 2001: The dot-‐com crash:
– Not that people overesQmated high-‐tech... – But they overesQmated how easy it would be to moneQze high-‐ tech...
• And today...
Today’s Crisis •
Cheap money from abroad: – The “global savings glut”...
•
Financial engineering:
– “InvenQng” new ways to to turn risky lead into safe well-‐hedged gold...
•
The corporate form and investment banking:
• •
The collapse of lending standards in housing... The belief that the risks were well-‐spread:
– In a partnership every thirty-‐something is a risk manager... – Today everyone is seeking large bonuses paid in cash on the basis of mark-‐to-‐model valuaQons at the end of the fiscal year...
– – – –
4 million homes x $150K per home... Only $600 billion of losses in mortgage-‐backed securiQes... In a $90 trillion global asset value economy... But the risks weren’t well-‐spread:
• They were concentrated... • Originate-‐and-‐distribute turns into originate-‐and-‐mark-‐to-‐model-‐and-‐collect-‐your-‐year-‐end-‐bonus...
Parenthesis: We Don’t Have too Much in New Housing Capital Anymore
Parenthesis: We Don’t Have too Many Workers in ConstrucQon Anymore
ImplicaQon: The Claim that We “Need” a Depression Is Incoherent • We don’t have any overhang of mal-‐investment... • We don’t have any excess employment in sectors where bosses need to be pushed by losses to shut factories and drive out workers... • John Maynard Keynes, 1932:
– Doubtless... the rate of growth of some individual commodiQes... could not always be in just the appropriate relaQon.... But, on the whole, I see liTle sign of any serious want of balance.... It seems an extraordinary imbecility that this wonderful outburst of producQve energy [over 1924-‐1929] should be the prelude to impoverishment and depression. Some... regard it both as an inevitable and a desirable nemesis.... It would, they feel, be a victory for the Mammon of Unrighteousness if so much prosperity was not subsequently balanced by universal bankruptcy. We need, they say, what they politely call a 'prolonged liquidaQon' to put us right.... And when sufficient Qme has elapsed for the compleQon of the liquidaQon, all will be well with us again...
If We Don’t in Some Sense “Need” a Depression, Why Do We Have One? • We have 10% unemployment... • We have 10% unemployment because spending is low... • Spending is low because: – A lot of people are unemployed and have less income... – A lot of people want to shib away from buying goods and bonds and put their porrolios in safe cash instead:
• A process reinforced by the fact that a lot of things that used to be seen as safe-‐as-‐cash—AAA mortgage-‐backed securiQes, anyone?—aren’t...
Cusng Edge Macroeconomic Theory —as of 1844 • Jean-‐BapQste Say, 1829:
– The Bank [of England]... obliged to redeem its banknotes in... gold... ceased to put new notes into circulaQon... cease[d] to discount... bills. Provincial banks... follow[ed]... commerce found itself deprived at a stroke of... advances.... As the bills that businessmen had discounted came to maturity, they were obliged to meet them, and finding no more advances from the bankers, each was forced to use up all the resources at his disposal. They sold goods for half what they had cost. Business assets could not be sold... a mulQtude of workers were without work.. bankruptcies were declared... merchants and among bankers... having placed more bills in circulaQon than their personal wealth could cover could no longer find guarantees... beyond the undertakings of individuals many of whom had themselves become bankrupt...
• John Stuart Mill, 1844:
– Persons... from a general expectaQon of being called upon to meet sudden demands, liked beTer to possess money than any other commodity... all other commodiQes were in comparaQve disrepute.... [T]he result is, that all commodiQes fall in price, or become unsaleable.... [T]here would seem to be in the nature of the case no parQcular impropriety in saying that there is a superabundance of all or most commodiQes, when all or most of them are in this predicament...
Only Two Significant Differences Between Then and Now • Say’s and Mill’s “commercial crises” involved a fibeen-‐ percent decline in a fibh of the economy—call it a 3% fall in real GDP relaQve to trend... • Our demand and producQon shorrall from potenQal today is approaching 10% of our enQre volume of producQon and spending... • Say and Mill knew that commercial crises were a new and unmanaged disease of industrial market economies... • Our economists only a liTle while ago were very confident that we understood the process and “won’t let it happen again...”
But Unfortunately... – John Stuart Mill, 1844, once again:
• What was affirmed by Cicero of all things with which philosophy is conversant, may be asserted without scruple of the subject... there is no opinion so absurd as not to have been maintained by some person of reputaQon. There even appears to be on this subject a peculiar tenacity of error—a perpetual principle of resuscitaQon in slain absurdity...
– There are lots of people out there who are sQll saying that we “need” a depression...
• ...or at least that we should not do anything out-‐of-‐the-‐ordinary to try to cut it short • Perhaps not important were it not for poliQcal backing from the Republican Party: – Very odd: Obama’s anQ-‐recession policies are quite close to what John McCain’s would have been... – But Republicans in congress are following the Gingrich strategy (Republican governors are very, very different...)
Indeed...
Not So Cusng-‐Edge Macroeconomic Theory—as in Academia Today • Three examples:
– Nobel Prize-‐winning University of Chicago Professor Robert Lucas:
• [When a large number of people are unemployed, it is because they] expect... a return to normal [wage] levels.... With these expectaQons, it is to a [worker’s] advantage to [decrease] his current supply of labor... when [wages fall].... [M]oney wages... fell noQceably below their ‘normal levels’ in 1930 [and] fell further below in subsequent years...
– Nobel Prize-‐winning ex-‐Chicago (now ASU) Professor Edward PrescoT:
• The period of the '20s was one of healthy growth, unQl Hoover's anQ-‐market, anQ-‐ globalizaQon, anQ-‐immigraQon, pro-‐ cartelizaQon policies were insQtuted, brought this expansion to an end, and created a great depression...
– Nobel shortlist Chicago Professor Eugene Fama:
• [P]rivate investment must equal the sum of private savings, corporate savings (retained earnings), and government savings.... Government bailouts and sQmulus plans seem aTracQve when there are idle resources—unemployment.... The problem is simple: bailouts and sQmulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and sQmulus plans do not add to current resources in use. They just move resources from one use to another...
ReacQons to Today’s Not so Cusng-‐ Edge Macroeconomic Theory •
A friendly criQque: FRBM President Narayana Kocherlakota: a “great forgesng,” a “great vacaQon,” a “great rusQng”: – Why do we have business cycles? Why do asset prices move around so much?... [Modern m] acroeconomics has liTle to offer by way of answer to these quesQons.... The sources of disturbances in macroeconomic models are (to my taste) patently unrealisQc... large quarterly movements in the technological fronQer... shocks to the marginal uQlity of leisure... shocks to the depreciaQon rate.... None of these disturbances seem compelling, to put it mildly...
•
An unfriendly criQque: Robert Solow:
– Suppose someone sits down where you are sisng right now and announces to me that he is Napoleon Bonaparte. The last thing I want to do with him is to get involved in a technical discussion of cavalry tacQcs at the BaTle of Austerlitz. If I do that, I’m gesng tacitly drawn into the game that he is Napoleon Bonaparte...
•
A “not so cusng-‐edge” rebuTal: Robert Lucas on Christy Romer:
– The Moody's model that ChrisQna Romer -‐-‐ here's what I think happened.... [S]omebody says, “you've got to come up with a... defense of this fiscal sQmulus...” So she scrambled and came up with these mulQpliers... [that]I don't think anyone really believes. These models have never been discussed or debated.... These are kind of schlock economics.... I think it's a very naked raQonalizaQon for policies that were already, you know, decided on for other reasons...
Does It MaTer that the Economics Profession Is Divided? • It would be nice if people adopted what I think of as the sound analyses of Say (1829) and Mill (1844)... • But many people are not: and they recommend policies: – Lucas: easy money, but no banking policy, no fiscal policy... – PrescoT: deregulate and cut taxes!... – Fama: ???
• And a whole bunch of others: NPR, the New York Times, Na3onal Review, the enQre Republican congressional caucus:
– All saying we should do nothing or we should do less than we are doing...
• I think that this does maTer, because this is not going to be over quickly...
Where Are We Going? Vs versus Ls
The S&P 500
Returns on Safe Debt at Historic Lows
The Problem Is Exactly What J.S. Mill and J.-‐B. Say Would Have Said • Excess demand for cash (and safe bonds): – Reinforced by the collapse of the supply of safe assets” • Or at least of assets that are perceived to be safe...
• Thus deficient demand for other things: – Risky bonds and loans to finance investment spending... – Goods and services...
• Reinforced by a vicious downward spiral...
Should We Wait for the Market to Cure It? • Prices will move; demands will adjust; supplies will respond to incenQves... • The prices of risky assets (and goods and services) will fall and that will boost demand; the high prices of safe assets will call forth more supply... • A “prolonged liquidaQon”... • Problems with a “prolonged liquidaQon”: – “Prices move” means wage cuts—which people hate... – “Prices move” means further falls in asset values—which means more bankruptcies: • And fewer rather than more safe assets...
– “More supply” means more private-‐sector financial engineering: • Do we really want that?
What Should the Government Do? • The big picture: – Boost the supply of safe assets: • Walras’s Law: if you have two markets and get one market back into balance, the other will come into balance automaQcally
– Boost the demand for risky assets: • Do so in a way that doesn’t set up yet more problems in the future...
What Is the Government Doing? • Boost the supply of safe assets:
– Guarantee risky assets—banking policy... – Sell off safe assets—monetary policy... – Make more safe assets—fiscal policy...
• Boost the demand for risky assets (and goods and services):
– “Restore confidence”... – NaQonalize enterprises (financial and non-‐financial) and tell them to spend and invest... – Invest in enterprises...
• Which should we do? All of them!
– We really don’t know which are most effecQve; we haven’t been here before...
• How much should we do?
– Remember: All these policies have downsides:
• Banking and industrial policy: public managers follow poliQcal rather than economic logic... • Fiscal policy: debt overhang... • Monetary policy: excessive liquidity provision triggering inflaQon...
But We Would See These Costs, We Think • If the market thought we were running out of room on fiscal policy...
– ...then interest rates on government bonds—especially TIPS—would be high and rising...
• If the market thought we were running out of room on monetary policy... – ...then the inflaQon premium between regular government bonds and TIPS would be high and rising...
• But do we trust financial markets to give us good signals? • Costs of banking and industrial policy harder to see at this Qme, but they are there: – Moral hazard... – Unjust enrichment... – Fear of “misallocaQon” and “inefficiency”...
• But an extra 13 million people unemployed and underemployed is the greatest misallocaQon and inefficiency of all...
How Will History Evaluate Us? • The view from Washington:
– The Bush administraQon and the Federal Reserve were blindsided by the problem: • • • •
Focusing on “global imbalances”... Overwary of regulaQon... Confident in the Federal Reserve’s ability to handle any situaQon on its own... Overly fearful of enabling “moral hazard”...
– The big mistake of Lehman Brothers... – But there is no Great Depression:
• 10% unemployment for a full year is not 20% unemployment for four years...
– And the Obama AdministraQon has done everything the sixQeth senator would allow it to do...
• My view: the glass is at least half empty... – ...but at least there is a glass...