Debtwatch No. 39 October 2009: In the Dark on Cause and Effect

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One of the keynote speak­ers at the 38th Aus­tralian Con­fer­ence of Econ­o­mists in Ade­laide last week was Edward Lazear, who was Chair­man of the US Pres­i­den­t’s Coun­cil of Eco­nom­ic Advis­ers from 2006-09.

In oth­er words, he was in one of the world’s eco­nom­ic hot­seats right when the “Great Mod­er­a­tion” (see also Ger­ard Bak­er’s UK Times arti­cle in ear­ly 2007) gave way to the Glob­al Finan­cial Cri­sis.

It was far from the hottest such seat: Bernanke as Fed­er­al Reserve Chair­man, and Hen­ry Paul­son as Trea­sury Sec­re­tary would have had much more uncom­fort­able back­sides at the time. But Lazear signed off on the Eco­nom­ic Report of the Pres­i­dent in 2007, 2008 and 2009, and was respon­si­ble for brief­ing the Pres­i­dent on the econ­o­my for those three years (as his suc­ces­sor Christi­na Romer does today).

Lazears’ keynote speech gave a very good feel for the pan­ic that was felt in the White House when the econ­o­my began to unrav­el in 2007, in strong con­trast to the for­mal fore­cast in the 2007 Report:

The Admin­is­tra­tion’ s fore­cast calls for the eco­nom­ic expan­sion to con­tin­ue in 2007 and beyond, although the pace of expan­sion is pro­ject­ed to slow some­what from the stronger growth of recent years. The unem­ploy­ment rate is pro­ject­ed to edge up slight­ly in 2007, while remain­ing below 5 per­cent. Real GDP growth is pro­ject­ed to con­tin­ue at around 3 per­cent in 2008 and there­after, while the unem­ploy­ment rate is pro­ject­ed to remain sta­ble and below 5 per­cent.

By the end of 2008, the unem­ploy­ment rate was 7.2 per­cent. The pre­dic­tion that unem­ploy­ment would not reach 5 percent—and vir­tu­al­ly every oth­er offi­cial fore­cast by the Coun­cil of Eco­nom­ic Advis­ers (CEA) from 2007 on—was wild­ly wrong. The sum­ma­ry of fore­casts from the Jan­u­ary 2009 report (which uses data from as late as Novem­ber 10 2008) is shown below.

Last week we learnt that the offi­cial OECD “U‑3” defined lev­el of unem­ploy­ment as of Sep­tem­ber 2009 was 9.8 percent—more than 2 per­cent high­er than the CEA’s end-of-year-2009 fore­cast, made just over a year ago—and the much more real­is­tic (but still incom­plete) U‑6 lev­el was 17 per­cent.

Lazear’s speech gave a very good feel for the sheer pan­ic that dom­i­nat­ed deci­sion mak­ing as the dis­as­trous year of 2007 unfolded—and as an even more dis­as­trous 2008 took its place. He also put for­ward his own inter­pre­ta­tion of what caused the cri­sis, and what the prospects were for growth from now on.

He pref­aced his remarks with the caveat that he was­n’t a macro­econ­o­mist: his spe­cial­ty was wage set­ting and remu­ner­a­tion in gen­er­al (this in itself is a sign of how com­pla­cent the government—and the eco­nom­ics profession—was at the time, by appoint­ing some­one to this key posi­tion whose spe­cial­i­ty was not macro­eco­nom­ics). So work­ing from his ground­ing in con­ven­tion­al neo­clas­si­cal macro­eco­nom­ics that he shares with most US econ­o­mists, he rea­soned that:

  1. The under­ly­ing cause of the US cri­sis was the high lev­el of Chi­nese sav­ings; and
  2. The US econ­o­my was like­ly to grow very quick­ly in the near future.

The log­ic for the first point went like this. Because Chi­nese sav­ings were extra­or­di­nar­i­ly high, Chi­nese finan­cial insti­tu­tions had lots of mon­ey to invest. As well as invest­ing in Chi­nese indus­try, they also invest­ed in Amer­i­can bonds. This encour­aged an increased sup­ply of risky bonds, and drove down the spread between them—especially those for Sub­prime mortgages—and safe bonds. That in turn fuelled the Sub­prime boom, and hey presto, cri­sis.

The log­ic for the sec­ond was that post-WWII expe­ri­ence has shown that the deep­er a reces­sion, the stronger the recov­ery from it. So since this down­turn had been so steep, a strong recov­ery was like­ly: he tipped a real growth rate of as high as 5 per­cent for 2010.

Lazear got lit­tle dis­agree­ment on these points from the oth­er almost exclu­sive­ly neo­clas­si­cal econ­o­mists at the conference—not nec­es­sar­i­ly because they thought his argu­ment was cor­rect, but because they had no viable alter­na­tive argu­ment as to why this cri­sis had begun.

Need­less to say I dis­agreed with both these argu­ments. We debat­ed these points, both in a ques­tion from the floor and in a good dis­cus­sion that Lazear ini­ti­at­ed with me on this top­ic dur­ing the pre-din­ner drinks. The dis­cus­sion was unfor­tu­nate­ly end­ed when Lazear had to take his allo­cat­ed seat. This Debt­watch out­lines what I would have told him, had we had the chance to con­tin­ue the con­ver­sa­tion.

Reverse causation

Lazear’s propo­si­tion that exces­sive Chi­nese sav­ings caused the finan­cial cri­sis is straight out of the neo­clas­si­cal macro­eco­nom­ics text­book, which por­trays the finan­cial sec­tor as the means by which those with excess funds from sav­ings lend to those with insuf­fi­cient funds, thus financ­ing the invest­ment the debtors wish to under­take. The Chi­nese save lots, so they have the excess funds; the Amer­i­cans were dis-sav­ing, so they had to bor­row the funds they need­ed for invest­ment (or rather ram­pant spec­u­la­tion) from else­where.

The first prob­lem with this argu­ment, which Lazear acknowl­edged in his speech, was that the  text­book would have pre­dict­ed that Amer­i­ca would be the saver and Chi­na the bor­row­er. Amer­i­ca is sup­posed to be the mature econ­o­my with high incomes, high sav­ings, and less oppor­tu­ni­ties for a high return on cap­i­tal, while Chi­an is sup­posed to be the devel­op­ing econ­o­my with low­er incomes, low­er sav­ings, and many oppor­tu­ni­ties for a high return on cap­i­tal.

But the real prob­lem with the text­book argu­ment is that its cause and effect rela­tions are, to put it blunt­ly, “arse about tit”.

The text­book argues that sav­ings must occur first before invest­ment can occur—and since the poor Chi­nese hap­pen to be good savers, while the rich Amer­i­cans are lousy savers, the finan­cial flows went from Chi­na to the USA. So the US cri­sis is all Chi­na’s fault.

In fact, the action in a cred­it-dri­ven econ­o­my begins with the lender: lend­ing cre­ates the mon­ey which—once spent by the borrower—turns up in oth­er peo­ple’s bank accounts. The actu­al causal sequence that gave us the GFC was there­fore:

  1. Amer­i­can lenders lent to Amer­i­cans to finance the hous­ing and stock mar­ket bub­bles, and copi­ous pur­chas­es of con­sumer goods as well as Amer­i­cans false­ly believed their wealth was grow­ing as house and share prices sky­rock­et­ed;
  2. These Amer­i­can bor­row­ers spent large slabs of this bor­rowed mon­ey on import­ed Chi­nese goods;
  3. The Chi­nese recip­i­ents of this Amer­i­can spend­ing racked up a large sur­plus of US dol­lars, which added to Chi­nese for­eign cur­ren­cy reserves;
  4. Some of these reserves were used to pur­chase US assets, includ­ing Sub­prime bonds but also gov­ern­ment bonds, equi­ties, and oth­er finan­cial assets around the world.

So the prob­lem began, not with Chi­nese sav­ing, but with Amer­i­can lend­ing. The huge for­eign exchange sur­plus­es accu­mu­lat­ed by the BRICs, Japan and to some extent Europe began in the prof­li­gate lend­ing of the Amer­i­can finan­cial sys­tem dur­ing its lat­est and great­est Ponzi bub­ble. They are a symp­tom of the prob­lem, but not its cause.

This argu­ment is com­mon­place in the Post Key­ne­sian school of eco­nom­ic thought—but for­eign to Neo­clas­si­cal think­ing, which still makes the mis­take of imag­in­ing that cred­it mon­ey is no dif­fer­ent to a com­mod­i­ty mon­ey sys­tem (like gold) where you can’t lend until you after you have accu­mu­lat­ed a stock of that com­mod­i­ty.

In fact, in a cred­it sys­tem lenders can and do cre­ate mon­ey sim­ply by the dou­ble-entry book-keep­ing process of cre­at­ing a loan and a deposit at the same time, as I explained  in the “Rov­ing Cav­a­liers of Cred­it” post. The fail­ure of neo­clas­si­cal eco­nom­ics to realise this is one of the major rea­sons why they don’t under­stand the econ­o­my. Instead they have a mod­el that might be of some assis­tance to a trib­al mar­ket­place in the New Guinea high­lands (or of some rel­e­vance to a medieval fair), but which bears no rela­tion to our mod­ern cred­it-based econ­o­my.

Dead Cat Bounce

Lazear’s hope that the econ­o­my would bounce back from the Great Reces­sion (as it’s now being described) was shared by the vast major­i­ty of econ­o­mists at the con­fer­ence. The basis of the hope was sim­ply his­tor­i­cal expe­ri­ence, where “his­to­ry” meant “what has hap­pened since World War II”.

The chart below, tak­en from the 2009 CEA Report, shows the pat­tern that Lazear, and most “green shoots” neo­clas­si­cal econ­o­mists are rely­ing upon: the deep­er the reces­sion, the big­ger the boom after­wards.

Even this looks far from reassuring—an R‑squared of 0.39 leaves a lot unex­plained. But there are also oth­er pat­terns in this data.

While growth did rebound to well above aver­age in the imme­di­ate after­math of most post-WWII reces­sions, this is truer of ear­ly post-WWII reces­sions than the lat­er ones—and it has only bare­ly been true for the last two reces­sions. In fact, after the 2000 reces­sion, growth bare­ly popped above the long term aver­age, spent most of the peri­od since the reces­sion below the aver­age, and was trend­ing down even before this reces­sion offi­cial­ly began.

The time trend is more obvi­ous when the dates of the reces­sions are replaced with the num­ber of years ago they end­ed (using 2010 as my ref­er­ence point, so the 57–58 reces­sion end­ed 52 years before 2010). The big slump-big boom pairs tend to occur ear­li­er where­as the more recent ones are small­er, AND the old­er ones are tend to be above the curve while the more recent ones are below. So this sim­ple lin­ear regres­sion obscures a time trend in the data.

There has also been a sub­stan­tial fall in the aver­age rate of growth over time—something the above chart can’t show, but which is appar­ent in the one below. Between 1950 and 1970, when Lazear’s rule of thumb clear­ly applied, the aver­age rate of growth was a very robust 4.27 per cent. Since then, when the rule of thumb clear­ly weak­ened, the aver­age has fall­en to below 3 per cent.

Clear­ly the US econ­o­my was already pret­ty sick before this cri­sis broke out: the pat­tern that Lazear and most neo­clas­si­cal econ­o­mists are rely­ing upon had already died. The only thing it appears well suit­ed to doing is grow­ing debt and finan­cial crises—which brings me to my final com­ment on Lazear’s speech.

Popcorn on the Oven

As any reg­u­lar read­er of Debt­watch knows, I am no stranger to analo­gies: I’m always look­ing for some para­ble that will tell an eco­nom­ic tale more acces­si­bly than a straight-faced descrip­tion of a mod­el or a set of data. Lazear showed that he was a fair hand at analo­gies too, with his descrip­tion of the “Pop­corn mod­el” of the finan­cial cri­sis that he said he advo­cat­ed while in office.

Oth­ers, he told us, sub­scribed to the “Domi­no” the­o­ry of finan­cial con­ta­gion, which was that the finan­cial sys­tem was like a set of domi­noes: if one fell over, the whole lot could fall over, but if they were all kept upright, none would fall. So all the effort went into ensur­ing that each mer­chant bank that got into dif­fi­cul­ty was res­cued, in the belief that this would stop the oth­ers from fail­ing.

Lazear instead used the anal­o­gy of pop­corn: if you put corn in a fry­ing pan, and remove each one that pops, that does­n’t stop oth­ers from pop­ping after­wards.

I liked the anal­o­gy, and ran with it in a ques­tion. I point­ed out that you can’t pop corn with­out turn­ing the heat on, the heat is pri­vate debt, and despite every­thing else they’ve done to con­tain the cri­sis, the one thing Amer­i­can author­i­ties haven’t done yet is to turn the oven off.

The corn is still a‑poppin’ as a result, as the most recent employ­ment data from the USA con­firmed. The scale of the cri­sis is still greater than any post-WWII reces­sion, and com­pa­ra­ble still to the Great Depres­sion, despite the wide­spread spin to the con­trary. This chart shows the lev­els of unem­ploy­ment rel­a­tive to the start of its increase in the Great Depres­sion, this reces­sion, and the deep­est post-WWII down­turn to date, the 1979–82 slump (which was a “W‑shaped” down­turn).

One rea­son why the USA has not man­aged to arrest the increase in unem­ploy­ment, where­as the Aus­tralian gov­ern­men­t’s stim­u­lus pack­ages have to date kept unem­ploy­ment in check (though hours worked and incomes are falling), could be sim­ply the much greater aggre­gate lev­el of debt in the USA.

Anoth­er is that Aus­trali­a’s stim­u­lus pack­age was main­ly giv­en to house­holds, where­as the US has put the mass of its funds into the finan­cial sec­tor in the mis­tak­en “mon­ey mul­ti­pli­er” belief that this will give more “bang for the buck”. As I not­ed in this post, a dynam­ic mod­el of the econ­o­my indi­cates that that belief is mis­tak­en, and Aus­trali­a’s approach of giv­ing its stim­u­lus to the debtors rather than the cred­i­tors was far more effec­tive.

Anoth­er not par­tic­u­lar­ly good rea­son is the far greater rate at which the US pri­vate sec­tor is delever­ag­ing, and the fact that some Aus­tralian gov­ern­ment policies—notably the First Home Ven­dors Boost—have encour­aged house­holds to return to lever­ag­ing up. Using Lazear’s extend­ed anal­o­gy above, we are avoid­ing a cri­sis by turn­ing the over tem­per­a­ture up.

Other reflections on the conference

I usu­al­ly don’t go to the Econ­o­mists Con­fer­ence, because it is dom­i­nat­ed by neo­clas­si­cal econ­o­mists, and I know neo­clas­si­cal eco­nom­ics far too well to take it seri­ous­ly. Con­verse­ly, neo­clas­si­cal econ­o­mists are vir­tu­al­ly unaware that there is any oth­er way of think­ing about the econ­o­my, take their own fal­la­cious method­ol­o­gy far too seri­ous­ly, and ignore papers writ­ten by mav­er­icks like me.

If I had pre­sent­ed this paper at a con­fer­ence in, say, 2006, there would have been vir­tu­al­ly no atten­dees at the ses­sion, while any neo­clas­si­cals who did show up would have vig­or­ous­ly object­ed to the fact that I did­n’t assume opti­mis­ing behav­iour, or effi­cient finance mar­kets, or the like.

Not this time how­ev­er. My ses­sion was packed (as was every ses­sion on the finan­cial crisis—and there were strik­ing­ly few of them), and the audi­ence includ­ed Robert Shimer, the edi­tor of the Jour­nal of Polit­i­cal Economy—which despite its name is one of the most con­ser­v­a­tive and neo­clas­si­cal­ly dom­i­nat­ed eco­nom­ic jour­nals on the plan­et. He appar­ent­ly advised Lazear to speak to me after my ses­sion (which Lazear could­n’t attend)—so maybe some chinks are open­ing up in the neo­clas­si­cal citadel.


Table One

Table Two

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