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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253 Responses to No-one saw this coming?” Balderdash!

  1. PETER_W says:

    By run­ning a Bal­ance of pay­ments deficit head­ing toward (7 — 9%) of GDP, Aus­tralia is import­ing $70 — 90 bil­lion of eco­nomic demand/stimulus per year.

    Our exter­nal trade cred­i­tor coun­tries are being far more gen­er­ous with their ‘Aus­tralian stim­u­lus’ than Rudd & Swan have been or the RBA 4% rate cuts for that matter.

  2. PETER_W says:

    I have to give it to Kevin Rudd in The Age this week­end… Polit­i­cally savy enough to skirt directly drop­ping a polit­i­cal nuclear bomb on the great Aus­tralian dream of easy lim­it­less wealth derived from hous­ing own­er­ship ‘at any price’…


    Causes of the cur­rent crisis…

    …Aus­tralian con­sumers also spent up big. Between 1996 and 2007, there was a 460% increase in credit card debt, a 340% increase in house­hold debt, a 450% increase in cor­po­rate debt and a 200% increase in net for­eign debt.

    Sec­ond, these debts were racked up on the back of sky­rock­et­ing asset prices. In sev­eral coun­tries, stock prices and house val­ues soared far above their true long-term worth, cre­at­ing paper wealth that mil­lions of house­holds used as col­lat­eral for their grow­ing debts.

    Given Kevin Rudds premises…

    Rapidly expand­ing house­hold debt in Aus­tralia
    House­hold debt is secured by inflated assets
    The illu­sion is paper wealth

    The log­i­cal con­clu­sion is…

    Aus­tralian hous­ing assets are over priced

    Should I assume even Kevin Rudd believes Aus­tralian houses are over priced?

    If Kevin Rudd is not going to directly inform the gen­eral pub­lic, then he should at least inform the real estate indus­try. They have laws with huge penal­ties about under and over priced mar­ket­ing of houses.


  3. ak says:

    The essay Kevin Rudd wrote is a direct attack at the Lib­er­als say­ing that the gov­ern­ment should not bor­row money and stim­u­late the econ­omy. He also wants to dif­fer­en­ti­ate him­self from the neolib­eral Coali­tion respon­si­ble for the cur­rent prob­lems. Only in this con­text he men­tioned the root causes of the cri­sis (the moun­tain of debt).

    What he says next is in my opin­ion very impor­tant — he is aware that the next phase of the cri­sis in Aus­tralia will not be easy for us. Per­son­ally I think he may still believe to some extent in the rapid recov­ery of the global econ­omy and the coop­er­a­tion of G20 coun­tries in build­ing the new global order.

    But what if this is all rub­bish? What if the US econ­omy (I’m not talk­ing about the casino econ­omy but the real one) keeps sink­ing at a steady pace? What if Rus­sia really wants to get Crimea back? What if China wants to look more after the inter­ests of the local com­pa­nies owned by the polit­buro rather than the multi­na­tion­als? What if sev­eral more “for­eign” exec­u­tives not loyal enough to the moth­er­land rot in jail? What if they just wanted to gauge the reac­tion of the west­ern gov­ern­ments before tak­ing on the Americans?

    Could Kevin Rudd just tell peo­ple — this is all going to col­lapse? No he couldn’t — he didn’t want to com­mit a polit­i­cal sui­cide. By the way I don’t believe in a col­lapse. I think it will be messy here in Aus­tralia but there will be no col­lapse thanks to the Labor gov­ern­ment. They are not true believ­ers in the rub­bish neo­clas­si­cal the­o­ries and if they have to redis­trib­ute the wealth — they will do it.

    Men­tion­ing ris­ing petrol prices may sig­nal the will­ing­ness to restore the trade bal­ance by low­er­ing the exchange rate of AUD what makes sense to me.

    There are 2 things the cur­rent gov­ern­ment are going to defend — house prices and employ­ment. There is a direct con­tra­dic­tion between ris­ing inter­est rates and house prices. Kevin Rudd didn’t men­tion that. Per­son­ally I believe that 10% mort­gage rates would mean the same out­come as in the US — the col­lapse. The mar­gin left for mak­ing any adjust­ments is very nar­row. How­ever there are a few more rab­bits left in the hat — they will be pulled when nec­es­sary. Regard­ing unem­ploy­ment it is still pos­si­ble to tem­porar­ily halt immi­gra­tion to Aus­tralia (what will have long-term adverse con­se­quences to skill short­ages) what would “fix” the prob­lem of unemployment.

    I think that we should not under­es­ti­mate the will­ing­ness of Kevin Rudd not to allow for dis­or­derly house bub­ble defla­tion at any cost even if there will be enor­mous mess cre­ated after­wards. But this is what we deserve and we should be thank­ful we have Kevin. We are not in the US and the Labor party is not a hostage of Wall Street as Barack Obama is.

  4. PETER_W says:

    I think you are right. The Aus­tralian paper wealth illu­sion can be maintained.

    An orderly 50% decline in the AUD would do it.

    Over 10 years it would imply ~ 7% inter­nal inflation

    The RBA could hold deposit rates at zero for 10 years

    The banks would have to adjust mort­gage inter­est rates up over time by roughly 40% X 7% or 2.8% because their com­mer­cial fund­ing cost com­po­nent would rise by 7%

    Wages would also have to rise with infla­tion (dou­ble over 10 years) and the nom­i­nal price of houses would have to remain fairly sta­ble but they would be down 50% in real terms (infla­tion adjusted).

    The illu­sion can be maintained.


  5. Josie says:

    Ueber­baer said:

    just think­ing.. so many econ­o­mists with the wrong mod­els and ideas…and so many cli­mate sci­en­tists also using mod­els and the­o­ries to explain their assump­tions and believes…”

    No, these are not equiv­a­lent in any way. The term ‘model’ is mis­lead­ing. Cli­mate mod­els are based on the laws of physics and chem­istry, which have been dis­cov­ered through empir­i­cal research over cen­turies. All they do is solve lots of equa­tions. Their out­puts are then tested against real data and found to repli­cate and pre­dict it very well.

    Econ­o­mists just make up their ‘mod­els’ and the­o­ries and equa­tions. That is what is so shock­ing about the sub­ject if you are used to sci­ence– none of it arises out of empir­i­cal research.

    Eco­nom­ics is psue­do­science. That has no bear­ing on real sci­ence. If econ­o­mists behaved like real sci­en­tists the sub­ject would be very different.

  6. A good book that need to be revived is The Cap­i­tal­ist Man­i­festo by Mor­timer J Adler and Louis O Kelso.

  7. SuitablyIronicMoniker says:

    Hi Josie,

    There is a lot of truth to what you say — but any pre­dic­tive model in a chaotic sys­tem will only have a lim­ited scope to see into the crys­tal ball. Futur­ol­ogy will always be an impre­cise sci­ence, due to those very same las of physics.

  8. Josie says:


    I don’t want to hijack this blog into a dis­cus­sion of cli­mate sci­ence, but it is not really true that the cli­mate is a chaotic sys­tem. Weather is chaotic, which is what pre­vents accu­rate long term weather pre­dic­tions, but cli­mate is the long run sta­tis­ti­cal aver­age, which is dif­fer­ent. The exam­ple often given is that you can’t pre­dict on the toss of a coin whether it will fall heads or tails, but you can make a pretty good esti­mate of the like­li­hood of get­ting dif­fer­ent num­bers of heads and tails if you toss it 1000 times.

    We are very famil­iar with the cli­mate being a very pre­dictable sys­tem, not a chaotic one. The sea­sons come in a reg­u­lar fash­ion. You may get a cold day in sum­mer (which is weather) but you won’t get all the days in sum­mer being colder than win­ter. If you turn down the sun, the tem­per­a­ture drops very pre­dictably. After a vol­canic errup­tion, the earth cools very pre­dictably. If you dou­ble the amount of an impor­tant green­house gas in the atmos­phere, the tem­per­a­ture rises.

    Of course there is a great deal of uncer­tainty in cli­mate sci­ence, and cli­mate sci­en­tists empha­sise it every step of the way. But not know­ing every­thing is very dif­fer­ent from know­ing noth­ing. If someone’s body is racked with ter­mi­nal can­cer you can’t pre­dict exactly when they will die, but you can pre­dict that they will almost cer­tainly not live another 20 years.

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  11. reason says:

    Inter­est­ing that my prob­lem with mod­ern day Geor­gians, is EXACTLY the same prob­lem that peo­ple had with the orig­i­nal Henry George’sCritics.pdf

    By the way, I didn’t reply to a request for links about increas­ing inequal­ity and declin­ing inter­gen­er­a­tional mobil­ity and declin­ing mar­ginal tax rates because it is not con­tro­ver­sial (i.e. there is so much evi­dence and dis­cus­sion about it), the request seemed sim­ply unrea­son­able time wast­ing to me. A good sum­mary here:

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  13. McMahon Michael says:

    I would like to add to your list of econ­o­mists with great foresight.William Kaye,an Amer­i­can based in Hong Kong writ­ing in The Far East­ern Review in 1999 could see the future.William Slat­tery in feb­ru­ary 2000 fore­cast here in Ire­land that a prop­erty col­lapse due to ris­ing pri­vate debt was inevitable.A Gary Shilling writ­ing in Forbes june 2006 fore­cast a hous­ing crash.
    I like the story that Pro­fes­sor Tom Woods of The Vom Mises Insti­tute in Amer­ica tells quot­ing Peter Shiffs book about the cir­cus com­ing to town and the local restau­rant owner see­ing so many clowns and trapeze artists fill­ing up his restau­rant every night decides to get a loan from his bank man­ager to expand his busi­ness and off course no sooner has he done that the cir­cus leaves town leav­ing him with empty tables and loans he can’t pay.
    Ire­land today looks like the town the cir­cus just left,only we seem to be left with the clowns still run­ning the show.
    In the US or Europe or even Aus­tralia nobody in author­ity had stud­ied the work on Lud­wig Von Mises,Joseph Schumpeter,Hyman Min­sky or Nicholai Kon­drati­eff.
    Steve,How do you com­pare this Great Reces­sion with 1873–1896.I think the ghost of Hetty Green is walk­ing down Wall St.
    Michael McMa­hon Ireland

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  16. Rentier Fungicide says:

    Many pre­dicted the cri­sis even fur­ther back, with time­lines less pre­cise, nat­u­rally, but argu­ing that defla­tion­ary col­lapse had been merely tem­porar­ily post­poned. Some of these accounts were more than prescient.

    In 1999–2000, for instance, Alain Parguez’s pre­dicted the finan­cial cri­sis in his arti­cle “The long-run fis­cal defla­tion: a real inter­pre­ta­tion of the late twentieth-century world cri­sis” in The Eco­nom­ics of Pub­lic Spend­ing: Debts, Deficits and Eco­nomic Per­for­mance, ed. Has­san Bougrine, Edward Elgar, Chel­tenham, U.K.

    As a taste of Parguez’s Min­skyan analy­sis, take the fol­low­ing paragraph:

    The plan­ners of fis­cal defla­tion dreamed of restor­ing the econ­omy of fear and power so as to pro­mote effi­ciency. They trig­gered a cumu­la­tive process that is destroy­ing the foun­da­tions of accu­mu­la­tion. The finan­cial cri­sis that occured in Japan, East Asia and other emerg­ing economies is a con­se­quence of this process. In the United States and Europe, the cri­sis is being post­poned by grow­ing house­hold indebt­ed­ness and a pure finan­cial infla­tion gen­er­ated by bank cred­its to finance merg­ers and acqui­si­tions of stocks by non-banking insti­tu­tions such as pen­sion funds”.

    Of course, insti­tu­tional investors played a smaller part than this para­graph sug­gests, but he pre­dicted this even before the col­lapse of the tech boom.

  17. Steve Keen says:

    Love your by-line!

    Yes of course, many oth­ers did; my ear­li­est call was 1995, but there were many oth­ers who fore­saw a cri­sis from a Min­skian perspective.

    Dirk Bezemer’s paper was look­ing for spe­cific pub­lic pre­dic­tions of this down­turn how­ever, which is why and a hand­ful of oth­ers got the guernsey, but there’s no doubt that many of those influ­enced by Min­sky both felt a cri­sis was highly likely from the early 1990s on, and said so in aca­d­e­mic pieces–though not in pub­licly acces­si­ble media as well.

    Alain and I met way back in 1996 by the way, when he invited me (and also Trond Andresen) to sub­mit papers to a spe­cial issue of Mon­naie et Pro­duc­tion on finan­cial crises. We’ve caught up sev­eral times since, at Post Key­ne­sian conferences.

  18. gweirydd says:

    Fred Har­ri­son pre­dicted the crash, with accu­rate dates, back in 1997, not 2005.

  19. Cahal says:

    I know this is an old post but Geoff Tily pre­dicted the crash fairly accu­rately in his 2007 book ‘Keynes Betrayed’ which is an excel­lent read, btw.

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  21. Ron Walker says:

    Hi again,
    I can­not con­fess to ‘see­ing this com­ming’. What I did see was from 2000 many peo­ple were get­ting into debt on a scale that it appeared nobody cared about how much debt you had just go and spend and they did.
    How­ever Prime Min­is­ter (PM) Cameron acusses (PM) Blair and (PM) Brown of delib­er­ately encour­ag­ing peo­ple to spend more than ever before. Since 2002 I per­son­ally took st

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  24. Kozak says:

    This is a very sim­ple expla­na­tion of the Min­skian moment that you can for­ward to your non econ­o­mist friends

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