Summary: Today we discuss the nature of the great monetary experiment now under weigh, with five years of zero interest rates and repeated doses of quantitative easing. What does it mean to say this is an “experiment”? If we cannot reliably predict the outcome, at least let’s understand how we got into this predicament.
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Contents
- What if Madame Curie built a nuclear reactor?
- Why? It’s a paradigm crisis in economics
- Why? Failure to reform
- Why? Failure to learn
- Conclusion
- For More Information
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(1) What if Madame Curie built a nuclear reactor?
The vital thing to know about the great monetary experiments began in 2008 – now underway in Japan, Europe, and America — is that these are experiments. There are no clear precedents, and certainly no successful precedents. Even the conditions are unique: stratospheric debt levels (both public and private) — aging populations — and a global financial system like nothing before.
That means those precise descriptions of possible outcomes we read, often giving odds of several outcomes, are just fancy guesses. Our gurus’ so confident predictions should be regarded as helpful guides to possibilities, nothing more. Things might evolve in ways we cannot now imagine. We cannot see into the next chapter, when the Fed tapers its purchases (or expands them if the economy slows).
Let’s try a Gedankenexperiment (thought experiment). Imagine if in 1910 Madame Currie not only refined a ton of pitchblende into 1/10 oz of radium, but then went on to produce much more. She shapes them into pellets, puts them into a bowl, and … something unexpected happens. A flash of blue light! Two days later she dies. It was a subcritical nuclear reaction (aka a criticality accident, see Wikipedia). Something she had no way to predict or understand. Experiments are like that.
If we can only guess at what happens next, we can know how we got into this fix.
(2) Why? It’s a double paradigm crisis in economics
Economists as a group have produced mostly incorrect predictions during the past decade, especially failing to predict the major events. The great crash, the sluggish recovery, and the Europe crisis starting in 2010. Here are two possible reasons.
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(a) We are living a Thomas Kuhn-type paradigm crisis in Keynesian economics, the theories by which the world economies have been steered for fifty years. In them the aggregate debt level of an economy is not a significant variable; attempts to integrate debt levels into orthodox theory by radical Keynesians (e.g., Hyman Minsky) were largely unsuccessful.
Debt levels, public and private, skyrocketed after 1980. Sometime after 2000 we reached and broke though the edge of the “operating envelope” of Keynesian theory. We ran like Wile E. Coyote off the cliff and beyond — a few exhilarating years — fell, and now we struggle to climb back.
(b) Economists’ models are mechanical, not organic.
Mainstream economics assumes a mechanical model of the economy. Turn the monetary crank clockwise and the red rod rises; turn it counter-clockwise and the red rod lowers. While analytically simple, it is quite daft to imagine the American economy works like that.
Large complex systems work differently. They adapt to inputs in subtle ways. Withdrawal of the input does not restore the status quo ante, instead it produces unpredictable new effects. Consider Prozac. Withdrawal from Prozac brings on strange new problems, not just the original depression.
(3) Why? Failure to reform
A defining characteristic of this cycle has been the major nations unwillingness to learn. After the crash the USA had an extra-large New Deal without any of the New Deal reforms. Europe has staggered along since its crises in 2008 and 2010 without any of the desperately needed reforms. The third arrow of Abenomics remains MIA. And the big expectations for reform from China’s Third Plenum meeting were predictably disappointed.
The massive response to the crash successfully stabilized the world economy, but that success drained the energy that should have driven reforms — reforms that could have laid the foundation for another generation of growth.
(4) Why? Failure to learn
On 1 July 1916 General Haig sent the British Fourth Army and French Sixth Army over the wire. That day they took over 57 thousand casualties. In some better alternate world, having achieved nothing and lost all tactical surprise, he called off the attack and ordered a complete rethink of their tactics. But in this world he continued the attack for another 140 days, advancing 6 miles at a cost of 624 thousand casualties.
We might surpass that record of stupidity (but fortunately not in terms of blood shed). Japan remains locked in stagnation since 1989 as its government debt goes to levels where no nation has gone before; it’s latest nostrum — Abenomics — so far has failed to achieve most of its objectives. The US remains at stall speed since 2010, despite running large fiscal deficits and two rounds of quantitative easing. Europe doggedly pursues a course with high odds of wrecking the societies of its southern members.
Perhaps we have grown sclerotic, a side-effect of our rapid aging. If it wasn’t for our dysfunctional political system, our younger demographics and higher fertility could be a competitive advantage.
(5) Conclusion
{Frito} remembered Bromosel’s ill-omened dream and noticed for the first time that there was a large blotch of lamb’s blood on the warrior’s forehead, a large chalk “X” on his back, and a black spot the size of a doubloon on his cheek. A huge and rather menacing vulture was sitting on his left shoulder, picking its teeth and singing an inane song about a grackle.
— From Bored of the Rings by Douglas Kenney and Henry Beard (1969)
All of this is quite obvious. Why then do we — optimists and pessimists alike — so strongly hold to our illusion that the outcome of this cycle is predictable? My guess (emphasis on guess): fear. We have used our illusions to suppress this fear, instead of allowing it to drive us to greater unity or creativity.
Perhaps fear will return, and arouse us to address our problems. Whatever the resolution, we will learn much from the next few years. Interesting times lie ahead.
(6) For More Information
(b) Monetary policy as addiction:
- Government economic stimulus is powerful medicine. Just as heroin was once used as a powerful medicine., 19 September 2013
(c) About the greatest monetary experiment, ever:
- Important things to know about QE2 (forewarned is forearmed), 21 October 2010
- Bernanke leads us down the hole to wonderland! (more about QE2), 5 November 2010
- The World of Wonders: Monetary Magic applied to cure America’s economic ills, 20 February 2013
- The World of Wonders: Everybody Goes Nuts Together, 21 February 2013
- The greatest monetary experiment, ever, 20 June 2013
- Different answers to your questions about the momentous Fed decision to delay tapering, 20 Sept 2013
- Do you look at our economy and see a world of wonders? If not, look here for a clearer picture…, 21 September 2013
- Two warnings about quantitative easing, the taper, and what comes next, 27 September 2013
- Dr Hunt explains the great monetary experiment. It will be historic, no matter what the result., 20 October 2013
- The great monetary experiment enters a new phase, with America as the stakes, 27 October 2013
- The key to understanding the future of QE3, and the future of our economy, 12 November 2013
(d) Other posts about monetary policy:
- The Fed is not wildly printing money, as yet no hyperinflation, we’re not becoming Zimbabwe, 2 March 2010
- Why the U.S. cannot inflate its way out of debt, 16 March 2010
- What are the limitations of the Fed’s power? It’s neither impotent nor omnipotent!, 17 September 2012
- Lessons from the failed forecasts of inflation since the crash, 5 October 2013
- Let’s learn about hyperinflation. Who knows what the future holds for us?, 21 October 2013 — esp section 3, about the sudden onset of inflation
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The Treasury is selling securities to primary dealer banks. One of two things happens to the securities. Either the Federal Reserve buys them (giving a commission to the primary dealers), or the primary dealers park them at the Federal Reserve as excess reserves.
Neither path gets the debtmoney into circulation in a real economy,
How does the Fed get the debtmoney into borrowers that can use self-liquidating debt to further the real economy?
Its a fairly simple question, but I think the eyes of the Fed are blinded by their theories. Bernanke and Yellen are academics. The Herman Hesse novel “The glass bead game” describes what happens to a cloistered academic when he meets the real world. (He misjudges the temperature of a lake and gets a fatal illness). I rather think similar situation is unfolding now; the theories haven’t been working for years.
Davidh,
They understand this problem quite well, and their theories for managing this situation were the basis for QE3. Especially managing expectations. This was all they could do, so they did it. Better to try and fail then be rightfully accused of failure to do their duty.
The results for GDP 2013 appear below expectations (again). They have hope for a better 2014, which will allow easy tapering.
On the other hand, they have blown a wonderful asset bubble. Financial assets, many kinds of real estate, art – zoom zoom. If this has produced a trickle-down wealth effect, it is not visible in the data.
Davidh,
“Bernanke and Yellen are academics.”
The 12 members of the a Fed Open Market Committee have diverse backgrounds. Bernanke and Yellen are academics, but their views are combined with those on the Committee with business and banking careers.
Everybody gets just one vote.
“Everybody gets just one vote.”
The composition of the open market committee is specified at:
http://www.federalreserve.gov/monetarypolicy/fomc.htm
I quote: “The Federal Open Market Committee (FOMC) consists of twelve members–the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis. The rotating seats are filled from the following four groups of Banks, one Bank president from each group: Boston, Philadelphia, and Richmond; Cleveland and Chicago; Atlanta, St. Louis, and Dallas; and Minneapolis, Kansas City, and San Francisco. Nonvoting Reserve Bank presidents attend the meetings of the Committee, participate in the discussions, and contribute to the Committee’s assessment of the economy and policy options.”
What if the deck has been stacked? As I see it, 7 out of the 12 are political appointments and only 5 out of the 12 are real bankers from the trenches. I am suspicious that the political appointments are true believer Keynesians/Friedmanites that either want to expand the money supply a lot or in a frequent and regular manner.
David’s,
“As I see it, 7 out of the 12 are political appointments and only 5 out of the 12 are real bankers from the trenches.”
Wow, that is a scary statement. So when did you become an opponent of democracy? All senior posts in the US government are “political” — a few by vote of the people, the rest by nomination by a politician and vote by other politicians.
As for “real bankers”, there is zero evidence they have any superior competence at setting macroeconomic policy — and considerable evidence most have little skill at it. Their main interest is in deregulating banks (boost their profits) and provide bailouts for the inevitable busts.
“I am suspicious that the political appointments are true believer Keynesians/Friedmanites that either want to expand the money supply a lot or in a frequent and regular manner.”
That is false on too many levels to even address. Neither Keynes or Friedman believe anything remotely like that, nor are there any schools of economics who advocate such a thing. We had thirty years of declining inflation until bankers’ excess lending blasted the economy into this hole, from which we have been slowly crawling out of.
Decades of propaganda of have produced millions of people indoctrinated with such faux history and faux economics, to the point they are a danger to the a Republic.
FM,
“A defining characteristic of this cycle has been the major nations unwillingness to learn. After the crash the USA had an extra-large New Deal without any of the New Deal reforms.”
Absolutely, and it is a basic tenant of economics that monetary policy can only improve the health of the economy in the long run if other factors like reform are involved.
But, we allow our banks to act as casinos, and we as a people like easy access to credit. Who doesn’t like owning a 3000 square foot house and buying the latest car every three years?
Our models assume that, collectively, we’ll act in our own self-interest. But, deregulation and easy access to credit has proven self-destructive.
I don’t know at what point we’ll realize that we need reform, but it pains me that any discussion of this issue becomes partisan.
Mike
MikeF,
You go to the heart of our problem, which I oversimplified (at 1200 words this was already too long). Our problem is not just failure to learn, but forgetting painfully lessons of the past.
We had good bank regulation and controls on lending! They were enacted during the previous down cycle — 1930s. They worked quite well for 40 years.
But memories faded and the bankers again grew powerful, and the regulations were one by one revoked. Soon consumer debt began to rise and bank failures multiplied.
This time we lack the political will to re-regulate the financial sector. They use their vast profits to buy politicians wholesale, so this will not be easy.
The experience of the Tea Party, born in opposition to bank bailouts, converted into supporters of bank-friendly Republjcans, suggests we might have decayed as a people to a frightening extent.
Bad debts don’t get paid. Best guess from the econophysicists, whose models are somewhat more “organic” than the economists’ in that they are more parsimonious and purely descriptive: a major deflation when the house of cards comes crashing down in about 2020.
See The Illusion of the Perpetual Money Machine at http://arxiv.org/abs/1212.2833
Benign,
I applaud the intellectual boldness of forecasting two decades ahead. But that’s wildly beyond the state of the art. Interesting, but cannot be taken seriously. Too many variable: political, social, economic — both domestic and global — most of which cannot be reliably forecast.
Here be dragons
http://en.wikipedia.org/wiki/Here_be_dragons
Todd,
That is easily a Best of a Thread winner. Sums up our situation perfectly. I will use that in the future!
The Fed’s Open Market Committee was not established until the mid 1930’s. This was part of the depression era New Deal that gave increasing amounts of control over the money supply to the government.
In the 1970’s during an era of high inflation and economic stagnation (in part due to oil shocks), the political establishment gave even more leeway to the Fed to increase the money supply.
(source http://en.wikipedia.org/wiki/Federal_Reserve_Act)
In 2008 the federal reserve started is large scale purchases of Treasury debt. It now competes with China for the title of “largest holder of Federal Debt”. The system was not suppoed to work this way. (source: http://www.ft.com/intl/cms/s/0/90618d30-4d05-11e3-9f40-00144feabdc0.html#axzz2kjy06qyq)
We are indeed in a “Thomas Kuhn-type paradigm crisis”, but I dont see that this crises is affecting the strategy or actions of the FOMC.
The current situation appears to be a replay of “The Triumph of Politics” 27 years later. (Credit to David Stockman for his 1986 book title). The evidence is in this graph:
http://research.stlouisfed.org/fred2/series/TREAST
I agree we need effective regulation of the banking system. I dont think a politicized Fed is up to the job.
For a contrast in an unrelated field: The current theories of dark matter have failed to describe reality. The nonconfirmation is hailed as a positive event, to go back to the drawing board and devise new theories to run with ever increasing sensitivity.
http://www.theregister.co.uk/2013/10/31/dark_matter_still_missing_after_100day_experiment/
David’s,
Your comment makes no sense whatsoever to me. I am not sure what you are attempting to assert, and your evidence doesn’t show any connection to what you say.
Pointing to a graph of Tsy securities held by the Fed and waving your arms as if that proves something is vintage Fox News, but meaningless.
“I agree we need effective regulation of the banking system. I dont think a politicized Fed is up to the job.”
I find your distrust of democracy as disturbing as your trust in bankers.
However, your statement is self-contradictory. The Fed’s history is one of bank-friendly bank regulation, as a large majority of its senior people have come the banking industry. So if you trust bankers, as stated in your previous post, you should trust the Fed’s regulation of banks.
Davidh,
Two more specifics about your comment.
“In the 1970’s during an era of high inflation and economic stagnation (in part due to oil shocks), the political establishment gave even more leeway to the Fed to increase the money supply.
(source http://en.wikipedia.org/wiki/Federal_Reserve_Act)”
Yes, that proved to be a mistake. The oil shocks were a new event in modern economies, an consensus economic theory at that time said that monetary easing was the appropriate response. Most nations implemented similar policies, hence the the global inflation.
Mistakes are part of history. Your history, mine, every institution’s. Especially in our rapidly changing world, where we face unique problems, and often find traditional solutions no longer work.
“In 2008 the federal reserve started is large scale purchases of Treasury debt. It now competes with China for the title of “largest holder of Federal Debt”. The system was not suppoed to work this way.”
So what? The world changes. Individuals, institutions, nations adapt or fail.
Fabius Maximus on Nov. 15 1:31P.M. stated:
“…we might have decayed as a people to a frightening extent.”
I’m beginning to think this is the key issue we face.
We may need to focus on the nature of this decay, causes, and how such a process (individually and culturally) might be reversible.
More concretely, this may involve more study of our collective and individual habits and ultimately raises the question of whether virtues can be learned? And if so, how?
Jim,
I totally agree with you. My posts about reforming America make a small start at grappling with these issues. The comments show readers near-total disinterest in doing so.
They prefer to seek the magic policy formula. Our politics are, in that sense, little but living the Wizard of Oz.
See these posts:
http://fabiusmaximus.com/tag/reform/
In Summer 07 I was having dinner with my banker, who at the time was a director on the board of Yellen’s SF Fed. He was asking for my forecast 12 mos out, both for my business and the macro economy at large. I had been tracking the eye-popping metrics on debt growth of all kinds (HY, MBS/CDO, CDS, etc.) I had also been following some in the hedge fund community who had been positioning for a major turn-down in the credit markets.
I was telling him a major change was in the offing — that was different from what he was seeing or hearing from most of his commercial banking clients. Now, it is never surprising when the establishment misses a turn, but what was shocking was how little attention these shadow banking metrics received from the Fed board (or at least in this case the SF Fed board).
The role of debt/leverage is hugely underweighted as far as I can tell, and certainly folks like Steve Keen have been highlighting this and pushing for new models which give credit/debt its proper due.
This is a paradigm crisis for the Keynesian school that has guided policy for 70 years. Hopefully the ignored/neglected theories of Minsky, Hayek, Fisher, Schumpeter, etc. will somehow be incorporated into a new orthodoxy. Unfortunately, the lessons to be drawn from those outside voices are best applied during the boom leading up to the bust. I’m afraid we have painful deleveraging and debt destruction to get to anything approaching a normal economy.
Bonesetter,
Thanks for the history. That mirrors my own history.
“The role of debt/leverage is hugely underweighted as far as I can tell”
More precisely, current models give little weight to debt (more precisely, leverage) levels.
Bank solvency is considered important, but unfortunately difficult to measure ex ante. In early 2008 there were many of us warning about the real estate bubble, but the expert consensus was that banks were unusually strong. The collapse of the world’s major banks was a surprise, and (as almost always) was the epicenter of the crises.
“certainly folks like Steve Keen have been highlighting this and pushing for new models which give credit/debt its proper due.”
Unfortunately that is not how Kuhn says paradigm crises work. An existing paradigm cannot be falsified, it can only be replaced. That takes a spark of creativity that comes in its own time.
“This is a paradigm crisis for the Keynesian school that has guided policy for 70 years. Hopefully the ignored/neglected theories of Minsky, Hayek, Fisher, Schumpeter, etc. will somehow be incorporated into a new orthodoxy. ”
Again, that is not how the standard descriptions of science as a process work. These theories are interesting, but cannot be integrated into useful theory because we need them or by an act of will or act of Congress.
Just as the Great Depression was occurred because nobody had read Keynes “General Theory” — published in 1936 — we have to work with the theory we have today.
In a rapidly changing world that means mistakes will be made, as genius appears when it wills, often recognized only after the crises hits (they ignored a Keynes’ insights on the Versailles peace treaty, which might have prevented the Depression and WW2.
X
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(a) We are living a Thomas Kuhn-type paradigm crisis in Keynesian economics, the theories by which the world economies have been steered for fifty years.
[…]
(b) Economists’ models are mechanical, not organic.
No doubt the failure of the economics profession as a whole has contributed greatly, perhaps decisively, to our failure to learn and to reform. When there is no consistent and useful message coming from the experts, charlatans, ideologues and vested interests propped up by motivated reasoning are left to set the agenda.
Two interesting pieces from 2009 stick in my mind:
Coises,
“No doubt the failure of the economics profession as a whole has contributed greatly, perhaps decisively, to our failure to learn and to reform.”
While I agree with Krugman and you about the error of the “freshwater” school of economists during this crises, I wonder if failure is too harsh a word.
The original — and IMO accurate — name for the field is political economics. Such conflicts are probably inevitable.
More broadly, as I said above, their paradigm crises is not a failure. Again it is just life. It is no more a failure than physists’ inability today to build a commercially viable fusion power plant.
I don’t think high-profile, respected representatives of the profession of physics declared that fission reactors are inherently stable, and that the problem of nuclear power station integrity has been solved, right up until Fukushima. (Some people said there was no significant danger, but that doesn’t appear to come close to the state of pre-2008 economics.) Nor are physicists known for arguing that if a meltdown begins, it should be allowed to run its course, since it is doing necessary work, and any attempt to mitigate it will only make eventual recovery more difficult; nor that there is no sense in investigating fusion, since fission has already been proven to be optimal.
(If you think I’m making up straw men, take another look at the Krugman essay. Influential economists have asserted propositions analogous to all of those things.)
From the Galbraith cited above:
Perhaps this is within the expected nature of paradigm shifts. Perhaps “failure” is too harsh. Perhaps it is inevitable that economics will sort itself out in the long run. It’s still a problem now. In the long run, we are all dead.
Coises,
I am inclined to agree with you. You make a strong case. But these people (e.g., freshwater economists) are not crazy, and there is some validity to some of their concerns.
Note Galbraith’s paragraph beginning with “The reason is not that there has been no recent work into the nature and causes of financial collapse. Such work exists. But the lines of discourse that take up these questions have been marginalized”. This goes to the core of the problem with economics. With modern political economics. Many areas are off the grid. In addition to those Galbraith mentions, there are others — touching upon questioning powerful institutions (e.g., attacking the Fed is bad for an economist’s career).
“for arguing that if a meltdown begins, it should be allowed to run its course, since it is doing necessary work, and any attempt to mitigate it will only make eventual recovery more difficult”
I don’t believe many economists recommended that during the recession. The initial fiscal and monetary (ZIRP and QE1) stimulus programs had broad support among economists. See this post with quotes by economic advisers of Bush Jr and McCain.
Opinions differed about stimulus during the recovery. Who is correct? It’s too soon to say. All we know is that we’re in the sixth year of this cycle and have not yet returned to trend (i.e., normal rates of growth, normal interest rates, closing the gap with potential gdp). Perhaps we have made a mistake. We’ve adopted the long stimulus programs of Japan since 1989. Perhaps they’ve put us into the path of long stagnation.
When this is over will be the time to paint economists are right and wrong. Until then I recommend caution.
FM wrote: “Your comment makes no sense whatsoever to me. ”
Agreed. Let me admit the mistake and attempt to recover.
On reflection, I realize I had a specific kind of banker in mind, the kind that made loans on the basis of character and collateral. They held the loans to maturity.
Today’s money center banks have a different kind of model, that of securitizing loans for sale to others. The consequences of bad decisions do not fall on the banker making the loan. In fact, I remember one tale of two subprime loan brokers discussing the problem of these loans, and how it would not affect them: “When they can’t repay, I’ll be gone, and you will be gone”. This may or may not be true but it illustrates the nature of the problem. I’m not sure if I’ve pointed it out here, but the Fed district banks are privately held by the banks in their district. It really makes no sense for the FRBNY (to name the biggest) to be a regulator.
The 2008 crisis was precipitated when everyone realized that many banks (especially Lehman) had mis-priced loans on their books. No one believed other’s balance sheets and the credit markets froze almost instantly.
Bernanke and Paulson infused capital by buying preferred stock in the banks(a political action). The mistaken lending was basically covered up with an accounting standards change (a political action) where banks got to account for the subprime debt as-if it were held to maturity.
Today, much of the mortgage lending is being bought by the Fed. I think this is an action to recue FNM and FRE which are in receivership and managed by the Treasury (political action again).
Also today, the Fed is buying a high percentage of the Treasury debt. They are enabling Congress and the Executive branch to continue to borrow money for current expenses. This enabling action is the basis for my reference to Stockman’s book, “The Triumph of Politics”.
Paying for current expenses by borrowing money has been going on for far, far, too many years. Someone has to realize that its not working and change direction. A paradigm shift is required.
I’m of the opinion that we will eventually have to make good on all the money we have borrowed & spent, and this will put all of us as a society in a world of hurt.
David,
You raise several important and complex issues, to which I lack the time to respond to now.
Two small points …
“On reflection, I realize I had a specific kind of banker in mind, the kind that made loans on the basis of character and collateral.”
Studies have consistently shown that modern credit scoring systems evaluate creditworthiness more successfully than banker’s judgement if character.
“They held the loans to maturity.”
Agreed. That change of business model had massive and unexpected consequences. However, it was forced on them by the disintermediation and the resulting collapse of lending margins.
This is a common cause of crises. Business conditions change, businesspeople adapt, the system changes in unexpected and substantial changes.
This is our world. The merry-go-round will not stop. We have to adapt better and faster.
A side issue: Federal district judge Jed Rakoff has been in the news lately.
http://finance.yahoo.com/news/judge-criticizes-lack-prosecution-against-001001592.html
An essay of his( do not have a complete link) is titled “Why Have No High Level Executives Been Prosecuted In Connection With The Financial Crisis?“, 12 November 2013. The final paragraph reads:
This is a side issue because government borrowing to pay current expenses has been going on for a very long time, long predating the 2008 crisis. Its a reason for the ballooning Fed balance sheet. In my view, the failure of making the people feel the pain of the governments expenditures in their name is a disconnect that needs to be remedied.
Its going to be hard to do this. Many promises have been made that will be reneged upon. A huge portion of the government budget is entitlement expenditures that can be funded only through this borrowing.
Davidh,
The judge might know the law, but little about economics. No surprise, because decades of propaganda have left Americans quite ignorant about the basics of economics.
“This is a side issue because government borrowing to pay current expenses has been going on for a very long time, long predating the 2008 crisis. Its a reason for the ballooning Fed balance sheet.”
Not a shred of truth in that.
In fact, the judge has it backwards. The deregulation of the New Deal-era bank regulations led to the financial crisis, and the resulting fiscal stimulus programs that prevented this — so similar in magnitude to 1929-1930 — from causing another depression.
We are in this hope in part from the judge’s disinterest in prosecuting the banker malfeasance which was in part responsible for the crises — and the equally bad and more blatantly banker lawbreaking which followed — the perjury and fraudulent foreclosures.
Perhaps we would be a stronger nation if judges were more solicitous of problems in their own field, and obsessed less about problems in areas they know little about.
The same could be said about that other serious running sore I our economy, the health care system. The bulk of those future liabilities you worry so much about are not retirement income benefits, but medical costs — which are the result of a system that costs 2x – 3x more than those of our peers, but delivers no better results.
The social security underfunding is a dot in comparison, a few percent of GDP.
David,
I added a link to the Judge’s full article.
Coises claims: “No doubt the failure of the economics profession as a whole has contributed greatly, perhaps decisively, to our failure to learn and to reform,” while Bonesetter Brown asserts: ““This is a paradigm crisis for the Keynesian school that has guided policy for 70 years. Hopefully the ignored/neglected theories of Minsky, Hayek, Fisher, Schumpeter, etc. will somehow be incorporated into a new orthodoxy.”
Let’s take a look at the recent historical record, shall we? Paul Krugman has successfully predicted low inflation and sub-par GDP growth using a Keynesian model with Fisher’s and Wicksell’s later additions. Meanwhile, the neoclassical DSGE economists as well as the Austrian school got it completely wrong.
The evidence here is not circumstantial: it’s as plain as the nose on your face. The Austrian school, following the disastrously foolish advice of Friedrich Hayek and suchlike cranks, imposed fiscal austerity on Britain. The result was, predictably, a collapse in GDP growth, plummeting aggregate demand, and even higher deficits due to the well-known “paradox of thrift” (initially discussed by Keynes, and elaborated by Fisher & Wicksell).
The “economics profession as a whole” did not fail — competent macroeconomists like Krugman and DeLong have long called for a larger stimulus and more active government intervention (in the form of CCC-type government work programs) to boost aggregate demand by getting cash into unemployed peoples’ pockets. The part of the economics profession that failed was the neoclassical crowd who kept assuring everything that (a) there couldn’t possibly be a general glut and a prolonged slump in aggregate demand because markets were self-regulating courtesy of the dynamic stochastic general equilibrium models they had ginned up; and (b) even if there was an economic downturn, it would surely be erased by a rapid V-shaped recovery.
The Austrians (austerians) and the neoclassical economists got it utterly, completely, totally, 100% wrong. Their predictions about sky-high inflation as a result of monetary easing down to the zero lower bound were wrong. Their predictions about the economic rebound after the 2009 global financial meltdown were wrong. Their claims that reducing deficits in Britain would result in a rapid increase of aggregate demand were wrong. Their claims that slashing the social safety net would increase “business confidence” and lead to more rapid economic recovery were wrong.
If, as Bonesetter Brown claims, the “ignored/neglected theories” of cranks like Hayek are “somehow incorporated into a new orthdoxy,” it will result in economic policies so disastrous that we’ll all wind up living in caves, banging rocks, and eating dirt.
The great leap forward for modern economics came in 1936 with Keynes’ General Theory. Friedrich Hayek and his ilk never provided any advice for dealing with the Great Depression other than the old long-debunked and thoroughly disproven nostrums of “liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.” (Treasury Secretary Andrew Mellon’s advice to Herbert Hoover in 1930.) We tried that for 4 long years back in 1930-1934. It nearly destroy the country. It sank the economy like a rock.
It’s work remembering that the Federal Reserve system was set up as a response to the near-collapse of the U.S. financial system during the Great Panic of 1907. Contrary to the implication that “only 5 of the federal reserve governers are real businessmen,” the Great Panic of 1907 that almost destroyed the U.S. economy was caused by “real businessmen.” And the evidence shows that “real businessmen” didn’t have a clue how to run the banking system. The Panic of 1907 only ended when J. P. Morgan agreed to put up a billion dollars of his own money to inject liquidity into the U.S. financial system, and convinced other financiers and banks to do the same. Not wanting to have to rely on one billionaire to save the economy, after 1907 the U.S. government decided to establish the Federal Reserve system in 1913.
“Real businessmen” caused every financial bubble and monetary panic in American history. The great leap forward in the American financial system was establishing regulation which reined in the more extreme fraudulencies of the “real businessmen,” as well as the establishment of a central Federal Reserve banking system which finally took the creation of money and interbank lending partially out of the hands of “real businessmen.”
Agreed, entirely, regarding 2009 to the present.
I think it’s reasonably non-controversial that there are two overarching “tool sets” in mainstream economics: neoclassical/freshwater/Chicago school and neoKeynesian/saltwater.
From the mid-1980s until 2008, both tool sets worked fairly well. According to the Krugman essay I cited, economists in those schools came to believe their differences had become minor and technical.
Neither predicted an event like 2008. I don’t mean predicted exactly what and exactly when—that’s far too high a bar to set—but mainstream economics wasn’t warning that trouble was brewing at all. It proposed that, perhaps with a few minor tweaks here and there, the economic conditions of the early 2000s were indefinitely sustainable.
There were voices crying in the wilderness. (See the Galbraith paper I cited.) They were dismissed.
Post-2008, as Thomas More points out, the neoKeynesian tool set has produced accurate predictions, while the neoclassical set has failed. That tells us that there are conditions under which the nK tool set works and the nC set does not. (We could have guessed that by remembering the 1930s.) It does not tell us that the nK tool set tells us everything we need to know. We only need to remember 2008 to see that it doesn’t.
Again, there are voices crying in the wilderness, such as Fabius Maximus warning us about the unknown effects of either prolonging or unwinding Quantitative Easing, and our unprecedented and ever-increasing total debt load.
The problem, of course, with voices crying in the wilderness is that most of them are usually wrong. Differentiating Cassandra and Nostradamus is not a job for novices like me. It is a job that the economics profession should be doing, instead of sulking or gloating, as the case may be, over which theory that failed to give any warning of the biggest financial crisis in three quarters of a century is working nicely just at this moment.
Coises,
I agree, nicely said.
(1). “It does not tell us that the nK tool set tells us everything we need to know.”
True, but who claims such a thing? I doubt that even a physist would make such a claim about his field.
(2). “The problem, of course, with voices crying in the wilderness is that most of them are usually wrong.”
True, and important to remember.
(3). “Differentiating Cassandra and Nostradamus is not a job for novices like me.”
Me, either.
(4). “It is a job that the economics profession should be doing, instead of sulking or gloating, as the case may be, over which theory that failed to give any warning of the biggest financial crisis in three quarters of a century is working nicely just at this moment.”
They are doing the best they can, just like the rest of us. New theories come in their own time, not ours.
The notion that no economic theory is an accurate forecasting tool all the time needs to be communicated to the electorate. Especially those who embrace either school. It needs to be understood by the politicians and their advisors need to keep that fact in mind.
My guess is that you are both correct – the professional economists are doing the best they can, but if the deciders ignore the facts about these competing theories are they doing the best they can?
Unfortunately, I hear too many people discussing politics and economics as though only one approach is correct. It sometimes seems that this has become a religion. Sunni’s and Shiites? Catholics and protestants?
doup,
“The notion that no economic theory is an accurate forecasting tool all the time needs to be communicated to the electorate.”
I agree, but I suspect that this is mission impossible. Polls show that about 1 in 4 Americans believe in astrology, which has been debunked for centuries.
People want to believe in guidance about the future. Hence scientists can achieve fame and fortune by making bold certain claims about the future, beyond the state of known science. We’re suffering from this in both economics and climate science.
My guess is that the only practical way to control this is through professional standards. Their peers have to push back on this. That is, however, probably also unrealistic to expect.
FM asserts: “Debt levels, public and private, skyrocketed after 1980. Sometime after 2000 we reached and broke though the edge of the “operating envelope” of Keynesian theory. We ran like Wile E. Coyote off the cliff and beyond — a few exhilarating years — fell, and now we struggle to climb back.”
Do you have any evidence to back up this claim? In historical terms, our debt is not unusually high — America’s debt was much higher during WW II. Krugman has pointed to an historical chart showing that the British Empire’s debt-to-GDP-ratio grew to enormously high levels at the height of its expansion, even as Britain’s GDP skyrocketed. Quite a number of economists have now re-examined and debunked Reinhart & Rogoff’s infamous claim about the alleged relation twixt GDP growth and debt levels.
Current U.S. levels of debt are moderate by historical standards. Where is the evidence to show that (a) such temporary debt levels are harmful, and (b) such debt levels are unprecedented in American history?
Thomas,
That’s a reading FAIL. I said total debt — public and private. Your references are all to government debt. The explosion vs historical levels is private sector debt, especially household debt.
From the Fed’s Q3 Flow of Funds report (US gdp is aprox $16T):
The usual credit ratio is debt to income. In this case debt to national income (GDP). Estimates of pre-WW2 total debt vary (there was little economic data collected before WW2; most of the long-term graphs you see are estimates). Estimates run in the mid- to high-200% range, peaking (of course) in 1929. With our superior financial machinery, we ran even higher before collapsing (much higher if one includes bank debt). Certainly to all-time record highs for a major nation.
.
“FM asserts: ‘Debt levels, public and private, skyrocketed after 1980. Sometime after 2000 we reached and broke though the edge of the “operating envelope” of Keynesian theory. We ran like Wile E. Coyote off the cliff and beyond — a few exhilarating years — fell, and now we struggle to climb back.’…Do you have any evidence to back up this claim?”
For what it’s worth, it seems to me that one piece of evidence backing up this claim at least with regard to private debt — given the axiom that debt is a contributing factor in growth due to the action of interest on the debt — is the unprecedented climb observed in the Dow Jones Industrial Average over roughly the same period of time. From 1982 to 2000, the Dow Jones Industrial Average climbed by more than 1000% (from 776.92 in 1982 to 11722.90 in 2000) — a rise which has never been equaled before or since. What was the reason for the jump?
At least one reason for the jump was the availability of cheap credit. There was a time not so long ago in this country when being in debt was regarded as a fairly serious personal failing — a sign of irresponsibility at best, and dishonesty at worst. However, at this point, it’s actually fairly unusual to find anyone in the middle or even the upper middle class who’s living within their means and not carrying some degree of debt.
One factor which I personally believe played a role in this is what I call the “cult of wealth worship” in our society which encourages people to calculate their own worth and those of other people primarily if not solely on the basis of material consumption and possessions. This trend seemed to take hold of the culture beginning in the 1980’s during the Reagan administration. One illustration of this is the emergence of the “yuppies” — another is the influence of this trend on the television programming of the period. Prior to the 1980′s, many of the popular television shows featured characters who were middle class or lower — Alice, All In The Family, Barney Miller, Good Times, Lou Grant, Maude, One Day At A Time, Rhoda, Sanford And Son, Welcome Back Kotter, etc. Beginning in the 80′s, a whole new genre of television drama began appearing in which the characters (whether fictional or nonfictional) were at least upper-middle class if not extremely wealthy — The Cosby Show, Dallas, Dynasty, L.A. Law, Lifestyles Of The Rich And Famous, etc. Even in the case of shows which depicted characters who would have been middle-class (such as say, 21 Jump Street or Miami Vice), the settings in which these characters interacted sacrificed realism for visual aesthetics — supposedly, the original concept for Miami Vice was summed up in the phrase “MTV Cops” — with the result that many of these characters were shown enjoying a lifestyle that they probably wouldn’t have been able to afford in real life. With some exceptions (such as Roseanne, the King of Queens, and 2 Broke Girls), the message of wealth worship has succeeded in remaining a significant force in television programming from the 1980′s through the 90′s and into the present day. This seems to have encouraged Americans to go out and spend more in an attempt to emulate what television was promoting as an ideal…and cheap credit made it possible for them to create lifestyles which gave them the appearance of being significantly more affluent than they actually were.
bluestocking,
“Do you have any evidence to back up this claim?”
I agree with you. Still, this thread illustrates a deeper and perhaps more important phenomenon — one shown in a thousand other threads on the FM website and countless others elsewhere.
When we started the FM website I looked forward to intense discussions about values, interpretations of history, different perspectives of the present, and alternative visions of the future.
Instead we spin our wheels locked I. Debate about matters of fact, usually simple matters of fact. Now for the bad news.
Usually presenting the facts changes no minds. We get assertions of more misinformation. Rinse, repeat.
I have a post soon speculating about the significance and consequences of this.
I think one of the factors which is playing a role in what you describe is the fact that (as I recently commented in response to another post on this site) Americans these days seem to care far more about ends than means, opinions than facts, and image than substance. If anything, this would seem to provide some support to the theory that this nation is becoming increasingly narcissistic — and only someone who’s spent most of the past few decades under a rock or on a deserted Pacific atoll would dispute that it’s become increasingly myopic.
It often seems as if a significant percentage of Americans no longer care whether something doesn’t work or doesn’t even make logical sense — the only thing they appear to care about is whether it looks, sounds, and feels good. For far too many people, anything which serves them and theirs for the moment is good regardless of what it might do to anyone else…or even what it might do to them in the long term.
The increased emphasis on immediate gratification within this culture has persuaded a growing number of people to choose the path of expediency (and this has been evident in ways other than economic)…but the trouble with this is that what is easy is often not ethical, while what is ethical is often not easy. If it were easy to be ethical, we probably wouldn’t need to have these kinds of discussions.
Bluestocking,
You might be correct. But…
“only someone who’s spent most of the past few decades under a rock or on a deserted Pacific atoll would dispute that it’s become increasingly myopic.”
How can we know such things?
Hard analysis of such things would take a team of social scientists, years of work, and lots of money. Since Congress will not even fund sufficient people to do quality control of the global temperature measuring systems (done, at least a few years ago, by a few people in addition to their other duties), they are unlikely to fund this.
My guess — emphasis on guess — is that the distorting of Americans views on these things is much narrower than you suggest, is mostly political in nature (I.e., affecting only a few subjects), and results from decades of intense indoctrination.
I have speculated about this in several posts, and got the same level of agreement as usual — near zero.
Now I must go and add to the growing lists of successful predictions on the Predictions Page: about Obsma, made in February 2008 (when the Obama as savior craze was gaining strength:
“As our problems reach critical dimensions and our economy sinks into what is (at best) a severe recession, our national leadership will likely move into the hands of someone with astonishingly little capacity to govern.”
One final note: davidh notes “In conclusion, I want to stress again that I have no idea whether the financial crisis that is still causing so many of us so much pain and despondency was the product, in whole or in part, of fraudulent misconduct.”
I have an idea. So does the FBI. So does the U.S. department of justice.
See for example, the article “FBI estimates that 80 percent of all mortgage fraud involves collaboration or collusion by industry insiders.”
Or the New York Times article “Robo-Signing Fraud Case Is Settled,” 15 February 2013.
I’m going to go out on a limb here and suggest that pleading guilty to a felony charge of conspiracy to commit mail and wire fraud means that fraud was involved.
The salient difference twixt the Great Depression and the 2009 global financial meltdown is that in the 1930s, large numbers of bankers and walls street investment bankers who committed fraud went to prison — whereas today, not a single banker or walls treet investment banker has yet done so (aside from Bernie Madoff, whose fraud did not involve subprime mortgage lending, now generally recognized as central to the 2009 economic bubble).
Interesting and productive set of comments. Good idea for the topic.
Astonishing how Rakoff’s remarks got confabulated with my own.
David’s,
Re judges remarks and yours.
No quote marks, although on re-reading I see you did say “one paragraph”.
I added the quote marks.
davidh wrote: “This is a side issue because government borrowing to pay current expenses has been going on for a very long time, long predating the 2008 crisis. Its a reason for the ballooning Fed balance sheet.”
FM wrote: “Not a shred of truth in that.”
Au contraire:
LBJ had a ‘guns and butter’ approach to financing the Vietnam war.
Stockman’s “Triumph of Politics” details how the Reagan revolution failed to achieve its promises because the Congress failed to implement the spending reductions that were planned to be paired with tax reductions.
Bush had a budget that failed to mention war and defense expenditures as “extraordinary items”.
Obama’s Treasury secretary claimed a smaller budget deficit at http://www.usatoday.com/story/news/2013/10/30/obama-budget-deficit-2013-first-time-in-five-years/3317193/
“The budget deficit for Fiscal Year 2013 dropped to $680.3 billion, the government reported Wednesday — the first time in five years the shortfall has been below $1 trillion.”
Using the USGov Treasury debt-to-the-penny site with dates to avoid irregularities due to the sequester
debt on 10/25/2012: 11353545059642
debt on 10/25/2013: 12121994254444
The actual debt for the year/over/year is $768 million.
This is the truth I’m talking about. Its a hell of a big number, especially since its the smallest in 5 years.
typo $768 billion not million
David,
What an odd reading. It is the equivalent of me saying me saying “the sky is blue, which is a reason my dog is so big”, to which you give a detailed proof that the sky is in fact blue.
The part to which I objected was the part you omitted: “Its a reason for the ballooning Fed balance sheet.”
The Federal deficit has no historical relationship to the Fed balance sheet.
This is the pattern in your comments, detailed but irrelevant replies. For example, about composition of the FOMC.
My guess is that you are learning absolutely nothing from this conversation, and it is a waste of my time. I have given extensive corrections to your statements, but I do not see the slightest acknowledgement of that.
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The title of your post is “How to predict the outcome of this great monetary experiment, and how we got into this box”. I though I was sticking to the topic.
We use Federal Reserve Notes (debt) as money. The examination of how this debt came to be is an essential part of predicting how the monetary experiment will play out.
Your statement “The Federal deficit has no historical relationship to the Fed balance sheet.” is dodging the main topic of your post, the “monetary experiment” which is in fact monetizing trillions of federal deficit. The Fed balance sheet is greatly increased over the past 5 years.
Federal debt is accumulated federal deficit on a year by year basis. I was attempting to get the true annualized deficit without the complications of the sequester by calculating the difference in total debt from one year to the next. If you know a more accurate way to do this, I’d certainly consider using your figures in reasoning about this “monetary experiment”.
David’s,
(1). “The title of your post is “How to predict the outcome of this great monetary experiment, and how we got into this box”. I though I was sticking to the topic.”
Quite so. Why do you ask?
(2). “We use Federal Reserve Notes (debt) as money.”
These are in a technical sense liabilities of the a Federal government. But they are not debt in any substantive sense. They pay no interest, have maturity date, and cannot be redeemed (since the Emergency Banking Act of 1933).
(3). “Your statement “The Federal deficit has no historical relationship to the Fed balance sheet.” is dodging the main topic of your post, the “monetary experiment” which is in fact monetizing trillions of federal deficit. The Fed balance sheet is greatly increased over the past 5 years.”
(A) I said “historical relationship”. The Fed is a century old, there is little correlation over the first 95 years.
(B). Yes, the Fed balance sheet has increased since the crash. But correlation is not causation, and does not prove the your statement that “Its a reason for the ballooning Fed balance sheet.” There are other reasons to expand the Fed’s assets, unrelated to the deficit.
(C). The government has had no difficulty borrowing funds at low rates.
(D). Can you cite an economist to support your belief?
The closest thing to a precedent for how future might go — Japan. I think anyone with even a superficial knowledge of how Japan has gone since the 90’s would feel the same way watching events unfold in the USA — that is I’m constantly in shock, “Oh my god, they are making EXACTLY THE SAME MISTAKES!” Bailing out banks, QE, nearly identical debates over budget deficits and everything.
It’s just that American exceptionalism prevents anyone from seeing this. We’re special, manifest destiny, lone superpower, blah blah. At least Japan was the first country going through this situation of high debt levels, real estate bubble, zero interest rates, etc. In the end I don’t know what America’s excuse will be.
So, going by Japan what would follow. In short, the upside is that the big crash never happens — they keep throwing money at markets and keep them from imploding. But, the downside is that basically they’ve wrecked capitalism and natural growth never returns — not next year, not next decade. Never. The zombie banks live and main street slowly rots.
Cathryn,
I agree, and have a post honing up making this exact point.
After I just finished berating mainstream economics… here’s something interesting:
===
To me, it seems like there’s still one more “radical” step to be taken.
It feels a bit as if an HVAC specialist explained to me that, for complex reasons (which he can detail convincingly), though it’s cold in my house, I need to turn the thermostat further down and it will get a little warmer. Things might or might not go back to normal someday, and it might never get as warm as I like, but for now that’s how it works. I would say the heating system doesn’t work.
If Summers and Krugman are correct, perhaps it’s time to admit that our economic operating system has one or more serious design flaws (not just miscalibrations), and quit assuming that minimally-regulated, minimally-redistributive free-market capitalism must define a near-optimal economic regime, no matter how bizarrely it functions.
When do you quit tweaking a system that appears incapable of producing the desired results, and start figuring out how to build a system that can?
Coises,
“When do you quit tweaking a system that appears incapable of producing the desired results, and start figuring out how to build a system that can?”
Interesting question.
Are you suggesting an even greater effort at central planning? Just the USA or the entire globe?
Doug,
“Are you suggesting an even greater effort at central planning?”
When the people do political reform it is the very opposite of central planning.
The alternative is a political economy designed by the politically powerful. Which is how the structure and rules of national economies are usually designed. That has always been clear to people going back to Adam Smith and beyond.
The myth that the system “just happens” has gained popularity due to decades if well-funded propaganda. Including things like a gross misreading and exaggeration of concepts like Smith’s “invisible hand.” It is a plausible as astrology, which it psychologically resembles.