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:
- The underlying cause of the US crisis was the high level of Chinese savings; and
- 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.
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:
- 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;
- These American borrowers spent large slabs of this borrowed money on imported Chinese goods;
- The Chinese recipients of this American spending racked up a large surplus of US dollars, which added to Chinese foreign currency reserves;
- 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.
END OF COMMENTARY