No-one saw this com­ing?” Balder­dash!

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The widely believed propo­si­tion that this finan­cial cri­sis was “a tsunami that no-one saw com­ing”, and that could not have been pre­dicted, has been given the lie to by an excel­lent sur­vey of eco­nomic mod­els by Dirk Beze­mer, a Pro­fes­sor of Eco­nom­ics at the Uni­ver­sity of Gronin­gen in the Nether­lands.

Beze­mer did an exten­sive sur­vey of research by econ­o­mists or finan­cial mar­ket com­men­ta­tors, look­ing for papers that met four cri­te­ria:

Only ana­lysts were included who:

  1. pro­vide some account on how they arrived at their con­clu­sions.
  2. went beyond pre­dict­ing a real estate cri­sis, also mak­ing the link to real-sec­tor reces­sion­ary impli­ca­tions, includ­ing an ana­lyt­i­cal account of those links.
  3. the actual pre­dic­tion must have been made by the ana­lyst and avail­able in the pub­lic domain, rather than being asserted by oth­ers.
  4. the pre­dic­tion had to have some tim­ing attached to it.”

On that basis, Beze­mer found eleven researchers who qual­i­fied:

Researcher Role Fore­cast Date
Dean Baker, US Co-direc­tor, Cen­ter for Eco­nomic and Pol­icy Research 2006
Wynne God­ley, US Dis­tin­guished Scholar, Levy Eco­nom­ics Insti­tute of Bard Col­lege 2007
Fred Har­ri­son, UK Eco­nomic Com­men­ta­tor 2005
Michael Hud­son, US Pro­fes­sor, Uni­ver­sity of Mis­souri 2006
Eric Jan­szen, US Investor & iTulip com­men­ta­tor 2007
Stephen Keen, Aus­tralia Asso­ciate Pro­fes­sor, Uni­ver­sity of West­ern Syd­ney 2006
Jakob Brøch­ner Mad­sen & Jens Kjaer Sørensen, Den­mark Pro­fes­sor and Grad­u­ate Stu­dent, Copen­hagen Uni­ver­sity 2006
Kurt Richebächer, US Pri­vate con­sul­tant and invest­ment newslet­ter writer 2006
Nouriel Roubini, US Pro­fes­sor, New York Uni­ver­sity 2006
Peter Schiff, US Stock Bro­ker, invest­ment adviser and com­men­ta­tor 2007
Robert Shiller, US Pro­fes­sor, Yale Uni­ver­sity 2006

Hav­ing iden­ti­fied eleven researchers who did “see it com­ing”, Beze­mer then looked for the com­mon ele­ments in the way that these researchers analysed the econ­omy. He argued that if there were com­mon elements—and if these dif­fered from the approach taken by the over­whelm­ing major­ity of econ­o­mists, who didn’t have a clue that a cri­sis was approaching—then the only use­ful eco­nomic mod­els would be ones that included these com­mon ele­ments.

He iden­ti­fied four com­mon ele­ments:

  1. a con­cern with finan­cial assets as dis­tinct from real-sec­tor assets,
  2. with the credit flows that finance both forms of wealth,
  3. with the debt growth accom­pa­ny­ing growth in finan­cial wealth, and
  4. with the account­ing rela­tion between the finan­cial and real econ­omy.”

A non-econ­o­mist might look at these ele­ments in puz­zle­ment: surely all eco­nomic mod­els include these fac­tors?

Actu­ally, no. Most macro­eco­nomic mod­els lack these fea­tures. Beze­mer gives the top­i­cal exam­ple of the OECD’s “small global fore­cast­ing” model, which makes fore­casts for the global econ­omy that are then dis­ag­gre­gated to gen­er­ate pre­dic­tions for indi­vid­ual countries—like the ones touted recently as indi­cat­ing that Aus­tralia will avoid a seri­ous reces­sion.

He notes that this OECD model includes mon­e­tary and finan­cial vari­ables, how­ever these are not taken from data, but are instead derived from the­o­ret­i­cal assump­tions about the rela­tion­ship between “real” variables—such as “the gap between actual out­put and poten­tial output”—and finan­cial vari­ables. As Beze­mer notes, in the OECD’s model:

There are no credit flows, asset prices or increas­ing net worth dri­ving a bor­row­ing boom, nor inter­est pay­ment indi­cat­ing grow­ing debt bur­dens, and no bal­ance sheet stock and flow vari­ables that would reflect all this.”

How come? Because stan­dard “neo­clas­si­cal” eco­nomic mod­els assume that the finan­cial sys­tem is like lubri­cat­ing oil in an engine—it enables the “real econ­omy” to work smoothly, but has no dri­ving effect—and that the real econ­omy is a mir­a­cle machine that always returns to a state of steady growth, and never gen­er­ates any pollution—like a car engine that, once you take your foot off the accel­er­a­tor or brake, always returns to a steady 3,000 revs per minute, and sim­ply pumps pure water into the atmos­phere.

The com­mon ele­ments in the mod­els devel­oped by the Gang of Eleven that Beze­mer iden­ti­fied are that they see finance as more akin to petrol than oil—without it, your “real econ­omy” engine revs not at 3,000 rpm, but zero—which can con­tain large doses of impu­ri­ties as well as hydro­car­bons. The engine itself is seen as a rather more typ­i­cal gas-guz­zler that pumps not merely water and car­bon diox­ide, but some­times unhealthy amounts of car­bon monox­ide as well.

That’s encap­su­lated in the flow­chart that Beze­mer copied from a paper by Michael Hud­son, shown below. With­out credit from the Finance sec­tor, producer/employers don’t get the finance needed to run their fac­to­ries and hire work­ers; but with credit they accu­mu­late debt that has to be ser­viced from the cash flows those busi­nesses gen­er­ate.

The com­po­nent left out of the above flowchart—but incor­po­rated in all the mod­els praised by Beze­mer for see­ing the cri­sis coming—is that the finance sys­tem can fund not merely “good” real econ­omy action but “bad” spec­u­la­tion on finan­cial assets and real estate as well. This also leads to debt, but unlike the lend­ing to finance pro­duc­tion, it doesn’t add to the economy’s capac­ity to ser­vice that debt.

The growth in thus unpro­duc­tive debt was the com­mon ele­ment iden­ti­fied by Bezemer’s “Gang of Eleven”, which was why we most def­i­nitely did see “It” com­ing.

I’ll fin­ish this anal­ogy-laden arti­cle with a side­swipe at an inap­pro­pri­ate one—that this cri­sis is “like a tsunami”. Though that image cap­tures the sud­den­ness and dev­as­tat­ing nature of the cri­sis, it is wrong not merely once but twice in char­ac­ter­iz­ing how it came about.

Firstly, unlike a tsunami, this cri­sis was pre­dictable by econ­o­mists who take what Beze­mer char­ac­ter­ized as a “Flow-of-fund or account­ing” approach. Sec­ondly, a tsunami is actu­ally caused by a huge shift in the planet’s tec­tonic plates, and the shift itself relieves the ten­sion that caused the tsunami in the first place: in a sense, the tsunami resets the sys­tem to a tran­quil state.

This finan­cial tsunami was caused by the burst­ing of asset price bub­bles dri­ven by exces­sive lev­els of debt, but the burst­ing of those asset bub­bles hasn’t elim­i­nated the debt—far from it. Instead, eco­nomic per­for­mance for the next decade or more will be dri­ven by the pri­vate sector’s attempts to reduce its debt lev­els, and this will depress eco­nomic activ­ity for years. Unlike a tsunami, a debt cri­sis is a wave of destruc­tion that keeps on rolling unless the debt is delib­er­ately elim­i­nated.

Every­thing that is being done by pol­icy mak­ers around the world is instead try­ing to restart pri­vate bor­row­ing. A bet­ter anal­ogy is there­fore not a tsunami but a drug overdose—and our “neo­clas­si­cal” eco­nomic doc­tors are attempt­ing to bring the patient back to health by admin­is­ter­ing more of the same drug.

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