Look at the economy. Fight the illusion of normality. Feel the weirdness.

Larry Kummer, Editor

12 years ago

Summary: I don’t believe I’ve successfully communicated to our readers the extraordinary nature of our times. We too often focus on the details, but ignore this essential aspect of our situation. Since the crash (perhaps starting even before) we’ve sailed beyond the edges of the known economic “space”. We can no longer even see the edges of the map.

Normal science, the activity in which most scientists inevitably spend almost all their time, is predicated on the assumption that the scientific community knows what the world is like. Much of the success of the enterprise derives from the community’s willingness to defend that assumption, if necessary at considerable cost. Normal science, for example, often suppresses fundamental novelties because they are necessarily subversive of its basic commitments.

— Thomas Kuhn’s Structure of Scientific Revolutions (1962)

Look at the US economy. Marvel at the oddness.

Near-zero interest rates since December 2008 — almost 6 years — scheduled to end in Q2 or Q3 of 2015.
Three rounds of quantitative easing (ending this month) taking the Fed’s balance sheet from $800 billion to $4,500 billion.– a trillion dollars added in the past year.
A mind-bending expansion of the Federal public debt, taking it from $5.1 trillion to $12.9 T (x2.5) — with $809 billion added during the fiscal year just ended (a 6.8% increase, equal to 4.7% of GDP).

That the economy needs such large stimulus in the sixth year of an expansion is unprecedented. Usually by now the economy has overheated from too-fast growth (inflation!), and economists are speculating about the next recession.

How we got here is equally strange. Like the Harry Potter books, since 2007 life has been a series of random plot twists. It will make a great novel; the film adaptation might be even better.

The long-expected housing bust,
followed by the collapse of some US investment banks,
then the collapse of the US banking system, shaking banks around the world,
followed by the collapse of world trade and a global recession in late 2008 (worst since the 1930s),
met by near-zero interest rates, a first round of quantitative easing (QE), and fiscal stimulus,
sparking a “v” shaped bounce in 2009, amidst predictions of return to normal growth,
which by late 2010 faded into another slump (real GDP in Q1 2011 was -1.5% SAAR),
successfully met by another round of fiscal stimulus and a second round of QE,
followed by predictions of return to 3% GDP in 2012,
which didn’t happen (GDP peaked in Q4 2011 at +4.6%),
followed by GDP slowing to near zero (+0.1%) in Q4 2012,
met by a third round of QE in September 2012 (ending this month),
and more forecasts of big growth in 2014, which didn’t happen (current estimates for 2014 are slightly above 2%).

Plus we saw a series of equally astounding events in Europe starting with the Greece bust starting in March 2010. And the July 2012 announcement that the ECB would “do whatever it takes to preserve the euro”. And the December 2012 “hail Mary” pass of Abenomics in Japan, attempting to end their quarter-century slump before the government goes bust.

No economists (and probably nobody else) predicted most of this, despite their confident forecasts (economists often write as if they’re the voice of God). But the persistent failure of their forecasts since 2007 does not mean they should abandon their theories. Kuhn explains why:

If all members of a community responded to each anomaly as a source of crisis or embraced each new theory advanced by a colleague, science would cease. If, on the other hand no one reacted to anomalies or to brand-new theories in high-risk ways, there would be few or no revolutions. In matters like these the resort to shared values rather than to shared rules governing individual choice may be the community’s way of distributing risk and assuring the long-term success of its enterprise.

Our reactions to these astounding events

The cumulative effect on me of these years has been disorienting, like Dorothy’s visit to Oz. We’ve enjoyed talking with the Lion, Tin Man, and Scarecrow. The yellow brick road is fun. We survived the flying monkeys and the Wicked Witch. When do we go home?

Most people have reacted differently to this series of events. They pretend that we’re still in Kansas, and this is just a New Normal. It’s a consensual hallucination, allowing these people to retain a feeling of stability and comfort. How long can they maintain this illusion, assuming we don’t return to Kansas?

Conclusions

{W}hen the profession can no longer evade anomalies that subvert the existing tradition of scientific practice — then begin the extraordinary investigations that lead the profession at last to a new set of commitments, a new basis for the practice of science. The extraordinary episodes in which that shift of professional commitments occurs are the ones known in this essay as scientific revolutions. They are the tradition-shattering complements to the tradition-bound activity of normal science.

There is an important group struggling to understand these events. How have economists, as a profession, reacted to the failure of their theories? At what point do they decide their theories need radical revision? The re-thinking has already begun. It’s a slow process, requiring a spark of creativity that comes only in its own time. Until then mistakes will be made as economists cope with our rapidly changing world.We have to work with the theory we have today, just as the Great Depression occurred because nobody had read Keynes “General Theory” — published in 1936.

Worse, having the solution is only have the cure. We often recognize genius only too late, as Europe’s leaders ignored Keynes’ insights on the Versailles peace treaty, which might have prevented the Depression and WW2 (The Economic Consequences of the Peace, 1919).

We can only wait for economists to produce new insights that generate operationally useful theories, and hope that we recognize them when hey arrive. Until then we should embrace the weirdness of our world, not ignore it.