naked capitalism

It is truly astonishing to watch how determined the economics orthodoxy is to defend its inexcusable, economy-wrecking performance in the runup to the financial crisis. Most people who preside over disasters, say from a boating accident or the failure of a venture, spend considerable amounts of time in review of what happened and self-recrimination. Yet policy-making economists have not only seemed constitutionally unable to recognize that their programs resulted in widespread damage, but to add insult to injury, they insist that they really didn’t do anything wrong.

Even worse, the latest excuse, from the Boston Fed, is that they are blameless because no Serious Economist could have recognized the bubble. From the Wall Street Journal Economics blog (hat tip Richard Alford):

Should economists and policy makers have identified the housing market bubble before it burst? The answer is most likely no, says the Federal Reserve Bank of Boston, because economic theory was not up to the challenge.

“Economic theory provides little guidance as to what should be the ‘correct’ level of asset prices — including housing prices,” the new paper published by the bank says. It was written by economists Kristopher Gerardi, Christopher Foote and Paul Willen.

“While optimistic forecasts held by many market participants in 2005 turned out to be inaccurate” those projections were not “unreasonable” given what was understood about the economy and housing market dynamics in the years before housing prices crashed and helped create one of the worst economic downturns in generations.

The paper notes economists were clearly not of one mind about the implications of rising housing prices. Some saw them as consistent with economic fundamentals, and driven by factors like the need for shelter to house a growing population, a favored explanation of central bankers themselves during those years. Others simply punted, offering no view.

Then there were those with negative views, many of whom have been sharply critical of the economics profession, and of policy makers.

“The pessimistic case was a distinctly minority view, especially among professional economists,” the paper observed. “The small number of economists who argued forcefully for a bubble often did so years before the housing market peak, and thus lost a fair amount of credibility” in the process. Others called a bubble with “arguments fundamentally at odds with the data” that became available after the fact, the economists write.

That paper notes that for the most part, regardless of the view economists held on housing, the science of economics wasn’t really even equipped to deal with the issue. “Academic research available in 2006 was basically inconclusive and could not convincingly support or refute any hypothesis about the future path of asset prices.” That meant anyone could argue anything.

Yves here. This recitation is truly embarrassing, in that the writers clearly see this abject failure as completely reasonable, as opposed to compelling evidence that the discipline is not qualified to provide policy advice. What could be more damning than admitting that economics was incapable of seeing the blindingly obvious?

The problem is that mainstream economics sees prices as a virtuous. Everything cal be solved by price. If there is some unbalance in the economy, it merely means prices need to rise or fall, the impediment must be stickiness or some other inefficiency that is preventing the magic price setting mechanism to do its magic work. Mainstream economists also believe that price mechanisms lead to optimal outcomes from a social welfare standpoint. There is a reason that this line of thinking. aka neoclassical economics, became dominant (and Keynsianism is merely a branch; Keynes himself believed economies were fundamentally unstable, while the neoclassical types believe that markets are always and every self correcting). It’s very favorable to the business community. (Note this is a simplification; ECONNED provides a long form treatment of this topic).

So there are quite a few reasons this “noneofuscouddanode” tale is sheer bunk. First is that economics is really really bad at fieldwork. How often do economists go and muck about in the phenomena they opine about? Nobel Prize winner Wassily Leontief, in the 1970s, did a tally of economics papers and found that a mere 0.5% had economists gathering data they then analyzed. The rest were pure theory papers or had the writers crunching data sets they had found. And on those rare occasions when economists do do their own data gathering, they are not very good at it due to the lack of interest in the profession in this activity. I’ve read surveys designed by economists to address particular issues, and it’s evident that they aren’t even remotely current with good, let alone best practices (for instance, asking people about their whether they will buy something or take an action relative to their finances is guaranteed to elicit wildly unreliable answers. No savvy marketer would use this approach).

Second, some very unfashionable schools of economics, namely the Austrians and the Marxists, both recognized the imbalances in the economy prior to the bust. It wasn’t just housing; the negative personal savings rate and the widening trade deficit with China were red flags.

Third is the through-the-looking glass logic: “Well, it took those (supposed) few who saw the bubble a long time to be proven right!” So how could you expect us to listen to them?” Huh? The bubble was hardly a secret, save maybe to central bankers (and that isn’t even true, William White of the BIS was issuing warnings as was ignored). The Economist made it a cover story in June 2005. And if the bubble had been arrested then, the damage would not have been very serious. The fact that it went on so long is perversely used as an excuse, when bubbles by nature go on absurdly long (as the recent example of the dot com mania vividly demonstrated). As we saw in this crisis, by the beginning of 2007, risk was so underpriced across all credit products that most market participants knew it was going to end badly, yet the vast majority stayed the course because exiting what might be too early had costs. Everyone acted as if they could all push through the door when the party stopped, and that of course proved false.

There is a good reason why economists may not be able to prick bubbles, but contrary to the Boston Fed’s lame excuses, it’s political. Ian Macfarlane, the former head of Australia’s Reserve Bank, did see that Australia’s housing market was overheated, and in 2004, used a combination of jawboning and a couple of interest rate increases to take some air out of it. But he was at the end of his term, and his successor did not continue with his efforts.

Macfarlane wrote in 2005:

Many people have pointed out that it is difficult to identify a bubble in its early stages, and this is true. But even if we can identify an emerging bubble, it may still be extremely difficult for a central bank to act against it for two reasons.

First, monetary policy is a very blunt instrument. When interest rates are raised to address an asset price boom in one sector, such as house prices, the whole economy is affected. If confidence is especially high in the booming sector, it may not be much affected at first by the higher interest rates, but the rest of the economy may be.

Second, there is a bigger issue which concerns the mandate that central banks have been given. There is now widespread acceptance that central banks have been delegated the task of preventing a resurgence in inflation, but nowhere, to my knowledge, have they been delegated the task of preventing large rises in asset prices, which many people would view as rises in the community’s wealth. Thus, if they were to take on this additional role, they would face a formidable task in convincing the public of the need.

Even if the central bank was confident that a destabilising bubble was forming, and that its bursting would be extremely damaging, the community would not necessarily know that this was in prospect, and could not know until the whole episode had been allowed to play itself out. If the central bank went ahead and raised interest rates, it would be accused of risking a recession to avoid something that it was worried about, but the community was not. If in the most favourable case, the central bank raised interest rates by a modest amount and prevented the bubble from expanding to a dangerous level, and it did so at a relatively small cost in terms of income and employment growth forgone, would it get any thanks? Almost certainly not…In all probability, the episode would be regarded by the public as an error of monetary policy because what might have happened could never be observed….

Looking back at the evolution of monetary and financial affairs over the past century shows that policy frameworks have had to be adjusted when they failed to cope with the emergence of a significant problem. The new framework then is pushed to its limits, resulting in a new economic problem. The lightly regulated framework of the first two decades of the 20th century was discredited by the Depression and was replaced by a heavily regulated one accompanied by discretionary fiscal and monetary policy. This in turn was discredited by the great inflation of the 1970s and was replaced by a lightly regulated one with greater emphasis on medium-term anti-inflationary monetary policy….

No one has a clear mandate at the moment to deal with the threat of major financial instability, but I cannot help but feel that the threat from that source is greater than the threat from inflation, deflation, the balance of payments and the other familiar economic variables we have confronted in the past.

Yves here. Now there are other measures that regulators can use to attack bubbles, since the ones that are most damaging involve borrowed funds. They can take measures to restrict the gearing used in the markets that are superheating. But Macfarlane’s comment about the resistance to intervening rings true. Just imagine the howling you would have heard from homebuilders, realtors, bankers, home decorators, land speculators, you name it, had the authorities been able to severely restrict no-doc loans and had required a minimum downpayment, say, of 10% for non FHA loans. It isn’t yet clear we have the political will to take on the people who win short term from borrowing binges.