“No-one saw this coming?” Balderdash!

Flattr this!

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.

Bookmark the permalink.

254 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.

  9. Pingback: President Obama ? - Page 6 - Cricket Web

  10. Pingback: The Irish Economy » Blog Archive » Learning from the Financial Crisis: Globally and Locally

  11. reason says:

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

    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:

  12. Pingback: 20091104 - Adam Crowe

  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

  14. Pingback: The great interest rate rip off - Page 703 - The Consumer Forums

  15. Pingback: Credit where credit’s due « forensicstatistician

  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.

  20. Pingback: Democracy Nowhere | Allcoppedout's Blog

  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

  22. Pingback: The Durban Roadmap to Extreme Climate Danger | Better Nature: commentary by Geoff Davies

  23. Pingback: 2007/8 financial crisis by Economics & Finance - Pearltrees

  24. Kozak says:

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


  25. Pingback: The Free Lesson in Political Theory « bnaught1

Leave a Reply