Wolfgang Munchau, in his latest Financial Times comment, “Recession is not the worst possible outcome” takes up a theme near and dear to our and many readers hearts: that policies to avoid recessions do more damage in the long run than letting slumps run their course.
Munchau is hard on economists, but not the purely academic type, but policymakers who endeavor to road test theories. A central element of Munchau’s piece is that central bankers rely heavily on the so-called “dynamic stochastic general equilibrium model” which as he discusses at some length, fails to incorporate elements many observers would regard as important.
Note Munchua’s Eurointelligence co-blogger (and fellow FT contributor) Paul De Grauwe gave a longer-form treatment of this topic recently. However, another FT writer, John Dizard, noted late last year that Bernanke discussed the Fed’s efforts to improve its DSGE models and indicated that the Fed does not rely solely on them. Nevertheless, Dizard seemed underwhelmed by its choice of alternatives (Dizard later argued that the Fed’s efforts to improve liquidity in banking markets were a departure from DSGE, but doomed to fail).
Munchau therefore advocates remedies that sound straight out of the IMF’s playbook circa 1997. Let housing fall as far as it needs to, raise interest rates high enough so that real rates are positive (horrors!), permit some banks to go bust (that’s gonna happen regardless, but I think Munchau means a big bank or two), plus some sensible longer-term policy remedies.
I can tell you with 100% certainty this will never happen. The mere idea of letting housing find its natural level (which Munchau thinks is 40% to 50% below peak prices) is politically unacceptable, so a great deal of effort and government resources will be expended to attenuate the inevitable. And per the 1997 analogy, Munchau may not appreciate what an unadulterated dose of his medicine might mean. We’ve remarked more than once that the America’s situation very much resembles that of Thailand or Indonesia circa 1997, except we have the reserve currency and nukes. In this case, the reserve currency is the more important element, for when the IMF’s harsh remedies were imposed, the rapid depreciation of local currencies meant that foreign currency denominated debts increased greatly in cost. Many businesses failed due to the rise in the debt burden. Now a currency depreciation won’t affect US borrowing costs to anywhere near the same degree, but consider nevertheless: Indonesia’s GDP fell by 13.5% in 1998. Would the US tolerate a fall of even 1/3 that much to get its economy back on track? Not voluntarily.
From the Financial Times:
If this had been a mere financial crisis, it would be over by now. The fact that we are suffering its fourth wave tells us there might be something at work other than merely financial euphoria and bad regulation. Maybe this is not a Minsky moment after all. Hyman Minsky, the 20th century US economist, formulated the long forgotten, and recently rediscovered, financial instability hypothesis, according to which capitalist economies, after a long period of prosperity, end up in a vicious circle of financial speculation. The Minsky moment is the point when what economists call this “Ponzi game” collapses.
But there might be better explanations. As the Bank of International Settlements said in its latest annual report, subprime might have been the trigger for this crisis, but not the cause. We do not have a full understanding yet of what happened but the BIS suggested that fast expansion of money and credit must have played a role. I would go further and say this is not primarily a crisis of financial speculation, but one of economic policy. Its principal villains are therefore not bankers, but economists – not in their role as teachers and researchers, but as policy advisers and policymakers.
So who are they? I recall a wonderful episode told by Jagdish Bhagwati in his book In Defense of Globalization when he quoted John Kenneth Galbraith as saying: “Milton’s [Friedman’s] misfortune is that his policies have been tried.” In fact, this is not the worst that could happen. The worst is for economists to try out their own theories themselves. This happened to several highly respected academics who have since become central bankers or finance ministers. If, or rather when, they turn out to be wrong, they risk a double reputational blow – as policymakers and as academics. So do not count on them to change their mind when the facts change.
Several of them have been leading proponents of an economic theory known as New Keynesianism. It is, in fact, probably the most influential macroeconomic theory of our time. At the heart of the New Keynesian doctrine stands the so-called dynamic stochastic general equilibrium model, nowadays the main analytical tool of central banks all over the world. In this model, money and credit play no direct role. Nor does a financial market. The model’s technical features ensure that financial markets have no economic consequences in the long run.
This model has significant policy implications. One of them is that central banks can safely ignore monetary aggregates and credit. They should also ignore asset prices and deal only with the economic consequences of an asset price bust. They should also ignore headline inflation. An important aspect of these models is the concept of staggered prices – which says that most goods prices do not adjust continuously but at discrete intervals. This idea lies at the heart of some central bankers’ focus on core inflation – an inflation index that excludes volatile items such as food and oil. There is now a lively debate – to put it mildly – about whether an economic model in denial of a financial market can still be useful in the 21st century.
So when economists tell us that we need to keep real interest rates negative, just as we did for long periods in the past 15 years, or that we now need to bail out homeowners and banks and raise our national debt in the process, or ignore any considerations of moral hazard while the crisis is raging, we might want to question whether the recipes that got us into this mess are also most suited to get us out again.
If we believe, as the BIS does, that a rapid expansion of money and credit has either caused, or significantly contributed to, the build-up of asset price bubbles and higher inflation, the opposite policy conclusions might be more appropriate.
Under this setting, the priority might be not to impede the fall in asset prices. Real house prices in the US, the UK and several other economies might end up falling by some 40-50 per cent, peak-to-trough, in the downward phase of this cycle. Let this happen and do not implement policies to prevent this fall – such policies might alleviate some pain in the short run for some people but will make the adjustment last a lot longer.
Second, monetary policy should be geared towards price stability first and foremost. When inflation expectations rise, real interest rates should be positive. This would necessitate a large interest rate increase in the US and further interest rate increases in the eurozone as well.
Third, allow some defaulting banks to go bust.
Fourth, implement long-term policies designed to reduce volatility. Among these are: a change in the monetary policy framework to take explicit account of asset price developments; the removal of pro-cyclical incentives in the banking sector; stricter regulation of mortgages, such as the encouragement of fixed-rate loans and the imposition of maximum loan-to-value ratios; more exchange-rate flexibility in countries with fixed or semi-fixed exchange rates and, of course, the development of alternative energies to reduce our reliance on oil.
We might run a greater risk of a recession in the short term. But a recession is not the worst possible outcome. The worst is for this crisis to go on and on, for Minsky’s moment to become an eternity.