Rob Parenteau, CFA, is sole proprietor of MacroStrategy Edge, editor of the Richebacher Letter, and a research associate with the Levy Economics Institute.
At a Brookings Institution session last March, while Bear Stearns was flaming out, Robert Rubin asserted “few, if any people anticipated the sort of meltdown that we are seeing in credit markets at present.” Der Spiegel recently carried an insightful piece on one of the few, former central banker William White (http://www.spiegel.de/international/business/0,1518,635051,00.html). White and his protégés at the BIS – the central bank for central banks – like Claudio Borio repeatedly stuck their necks out to warn of the financial imbalances building in the global economic system. In contrast, most of their colleagues in central banks, backed by the prevailing mainstream macroeconomics, mistakenly asserted that inflation stability would insure both stability in economic growth and financial stability. Indeed, this was part of the narrative that central bankers like Chairman Bernanke took up with their Great Moderation story.
Similarly, Nassim Taleb has gained notoriety for his view that the recent episode of financial instability is an example of a Black Swan event – a type of “tail event” that will randomly disrupt human affairs because we tend to systematically clip off the extremes of the possible when examining the range of likely outcomes. Yet a recent paper by Dirk Bezemer at Groningen University, “No One Saw This Coming”, however, documents that dissenting voices were there to be heard, if one was only willing to listen (http://mpra.ub.uni-muenchen.de/15892/1/MPRA_paper_15892.pdf).
This in itself is not entirely surprising – after all, financial markets require bulls and bear if any trading is to actually occur, and there is always a contingent of knee jerk contrarians, misanthropes, and malcontents known as permabears willing to spin the doom and gloom narrative. However, what Bezemer uncovered is that an identifiable common thread ran across the dissenting views.
The dissenters, Bezemer found, shared an emphasis on a stock/flow coherent macroeconomics. That is, starting from what should be an uncontroversial, accounting based view that at the level of the economy as a whole, total income must equal total expenditures, and total assets must equal total liabilities, those who saw this coming were able to identify unsustainable sectoral cash flow and balance sheet developments. In advance, a stock/flow coherent macroeconomics revealed the reasons why the Great Moderation was bound, by construction, to eventually give way to the Great Disruption.
As Bezemer put it,
“Surveying these assessments and forecasts, there appears to be a set of interrelated elements central and common to the contrarians’ thinking. This comprises a concern with financial assets as distinct from real sector assets, with the credit flows that finance both forms of wealth, with the debt growth accompanying growth in financial wealth, and with the accounting relation between the financial and real economy.”
Having performed one such analysis for the Levy Economics Institute in 2006 (http://www.levy.org/vdoc.aspx?docid=866) and studied financial instability reports issued by the Levy Institute, the BIS, the IMF, and others prior to the recent financial crisis, we believe Bezemer has it largely correct. If policy makers are indeed serious about the “never again” pledge regarding a financial crises the size of the recent one, they will need to set aside the prevailing macroeconomic paradigm – one which has largely made itself irrelevant by approaching macro as little more than aggregated microeconomics. Instead, they will need to become familiar with a stock/flow coherent macroeconomics that highlights the way financial conditions can shape economic outcomes. This is an economics examined and utilized by J.M. Keynes, Irving Fisher, Hy Minsky, Wynne Godley, Kurt Richebacher, and others – it is an economics especially relevant to the world we actually inhabit.
When a plane crashes, investigators swarm over the site and retrieve the “black box” in order to determine the cause of the crash, with the aim of reducing the odds of future crashes. In that fashion, knowledge it built over time about what works and what does not work, and appropriate adjustment in technology or best practices can be made along the way.
Little in the way of such procedures appears to be set in motion following a financial crash. Given the ability of financial crises to disrupt the lives of more people than can fit on a plane, this should strike most people as somewhat cavalier, if not absurd.
Some, like Bill Black, have suggested nothing less than a modern version of the Pecora Commission should be launched (http://neweconomicperspectives.blogspot.com/2009/07/some-want-whole-truth-about-what-went_13.html). We are no fans of witch hunts, but we do believe ignoring useful frameworks for understanding financial instability, and leaving applied analysis based on these frameworks essentially ignored or marginalized, is unlikely to benefit anyone except those who gain the most from manufacturing and milking serial asset bubbles. Any attempt at an autopsy of the Great Disruption must go beyond cataloguing the inherent fragilities of the financial instruments and specific market structures themselves, as well as the flawed incentive structures and ample room for fraudulent practices, to a serious examination of the unsustainable macrofinancial dynamics that were either ignored or simply explained away.
If macroprudential supervision or any such related effort at reducing the odds of systemic economic crises unfolding from financial instability is to be successful, the core analytics will need to be built around a stock/flow coherent approach macroeconomics. The ground work in this area has been already been done by the likes of Claudio Borio, Wynne Godley, Levy Institute research associates, and others working in financial stability projects within various national and international institutions. Without paying attention to unsustainable sectoral cash flows and the resulting balance sheet leverage building up over time, financial vulnerabilities that can trip up the entire economy – indeed, as we have seen, the entire global economy – will remain largely invisible to investors, entrepreneurs, and policy makers. Perhaps that serves the interests of asset bubble perpetrators, but after recent events, it is high time to question whether those interests should remain paramount.
Bob Rubin is right – a few people did see an episode of financial instability brewing. Dirk Bezemer is also correct – these people tended to share a common approach to viewing economic and financial dynamics. That this framework is not being used to explicitly inform solutions to the current crisis is dumbfounding. That attempts to reduce the odds of future episodes of financial instability may not incorporate this framework, which after all is grounded in relatively straight forward and uncontroversial accounting, is senseless.