Wolfgang Munchau: Maybe the Economists Are to Blame After All

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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.

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  1. a

    I love it! Down with the New Keynsians!

    Maybe the U.S. will never allow Munchau’s policies, such as a fall in U.S. GDP, but I’m sceptical that anything can be done to prevent some of the dire consequences. Sure the U.S. can probably keep up nominal GDP, but real GDP is another matter. Sure the US can probably keep many of its banks from going bust, but only at the expense of nationalizing them, and then (probably) having the dollar and/or Treasuries tank, which seems to me pretty much the same thing.

  2. Anonymous

    Great article but it will never happen voluntarily. The only way for all of that to happen is if another country was able to become the reserve currency of the world and force the needed changes. As it is now no one wants to blink first. China, Japan et all will keep on buying a depreciating currency because they have a lot of it and therefore the USA is “too big to fail” as far as they are concern. So they will keep on bailing the US out. What really surprises me is that the EU does not try to take over the US as the reserve currency with all the freebies that it entails.

  3. Independent Accountant

    I have been saying for months, either the banks fail or the dollar fails. Why is Hank Paulson at Treasury? Why do guys like Robert Rubin float in and out of government? Got gold? Get more!

  4. Anonymous

    I think the US central bankers are very aware of the inflation problem but at this point they view inflation as the lesser evil to a credit crunch. Look at US economic history, in their eyes the inflation of the late 1970s was curable after dramatic CB hikes in interest rates while the 1930s depression failed to respond to any CB policies.

    Pushing on a string is tougher than pulling on a string…

  5. theinvestingspeculator

    I agree with Munchau. All the central bank is doing is prolonging the day of reckoning. I agree with Jim Rogers-when he say we should get rid of the fed. What do they do. Growth is down, inflations is up all over the world. I did a chart of inflation rates @

  6. One Salient Oversight

    I love this line of thinking… really. I have been arguing for years that loose monetary policy is going to cause a big crash, and now that this crash is upon us, we should not assume that the policy which created the problem is therefore the only solution.

    Otherwise you just end up inflating, inflating, inflating.

    Yes, real rates should be positive – they should ALWAYS be positive.

    Moreover, I would argue that one of the great lessons of the post 1970s period is that even small levels of inflation are bad.

    All over the world, central banks (like the ECB) have “inflation targets”. My opinion has always been that prices should be stable – and that means stable, not even inflating slowly.

    Inflation targets should actually be zero – “Absolute Price Stability” is what I call it. This is not some price fixing experiment, but rather a policy which ensures that, over the course of the business cycle, there is neither inflation nor deflation.

    I’m glad that there is a growing voice for interest rate hikes and intelligent fiscal policy. I say jack up the rates to kill inflation, balance the budget (military spending can be cut) and let the cards fall where they may.

    Painful? Sure. But it has to be done sooner or later.

  7. Peripheral Visionary

    I have long considered the words “dynamic” and “stochastic” to be utterly meaningless, academic-babble words that academicians use to maintain distance between themselves and the untenured rabble outside of the ivory tower. That both of those words appear in the name of a theory does not, in my view, bode well for the reliability of the theory in question.

    The “Dynamic Stochastic General Equilibrium Model” has run its course; I think it’s time we started looking for the “General Unified Optimal Dynamic Heuristic Stochastic Model”.

  8. Anonymous

    “New Keynsian” ?

    Keynse was well aware of the potential for high power money to stimulate and relieve a deflating economy. He was also aware, and advocated, a balanced budget during the good times.

    These jagoffs have been full speed ahead on monetary stimulus, fiscal stimulus, debt stimulus, since the grifters took office.

    The unholy alliance between acadamia and the neutron-cons have looted the US economy and made it unstable. Let’s throw out the “new” theorey and follow our common sense, for a change. We have thrown out the lessons learned from the Great Depression. Don’t turn our backs on the banking or financial industry.

  9. Bill C

    While there may be grounds to second-guess Fed policy, it is ridiculous to suggest that Bernanke – or economists, generally – are blindly in the grips of a single, DSGE New Keynesian model. All economic models, by necessity, are over-simplified, but economists know this (ok, sometimes we forget..). Bernanke has done important work on the great depression and the role of the financial sector in propagating crises, as well as on inflation targeting, both of which are relevant here.

  10. James

    “High-Grade Structured Credit Strategies Fund”

    “Dynamic Stochastic General Equilibrium Model”

    Both are BS

  11. Anonymous

    I think that the US problems are not repeating the 1930’s great depression. That crisis was generally an overheating, with too much of the money and resurces going into investment, so that demand couldn’t keep pace with supply, and after the turning point, that it became evident for all, investements came to a halt, too, further reducing demand in the economy.

    Now the situation is completely different, there is way no overheated economy in the US, instead there was a prolonged trade imbalance toward low-cost contries, from where million tons of goods, and money have been imported. Exactly because rates in the US was higher, or safer than in the source countries, so they sent back the money they got from selling their products, so americans could never run out of money. Until now. Now, the Us economoy is struggling with a heavy load of debt both in the personal, the government, and the companies side, while there is an outsourced economy from which they could repay the debt.

    Very likely, that if any solution exists for this situation for the US is first to stop further money pump from the eastern economies, and second to inflate the already present debt… and that’s quite close to what the FED is doing there.

  12. Andrew Teasdale

    One of the reasons we are in this mess may be to do with the way broad money supply growth tapered off from the late ’80s to early ’90s; this appeared to sever the money supply/inflation relationship.

    In fact, it is plausible that the excess cash balances that had been accumulated during the higher inflation/interest rate period were being reallocated to either economic or financial transactions as the need for cash balances fell: broad money supply did not need to grow as much to finance economic activity.

    Ever since 1995 we have experienced an unparalled surge in excess money supply growth (Broad MS less nominal growth as a function of inflation); this surge has been virtually ignored in terms of monetary policy and it is this surge aided by a number of other unique factors that is behind the size of the asset price bubble.

    Trouble is, once you get to this point in time – rising inflation, higher interest rates, uncertainty etc – preferences for higher cash holdings rise; higher preferred cash levels means that when central banks try to use monetary policy to stimulate economic activity they will find that monetary policy cannot influence broader monetary aggregates.

    Japan is a good example.

    Andrew Teasdale

    The TAMRIS Consultancy

  13. S


    you give yourselfaway with the “we”

    bernanke is an absoloute disaster but trumping him may indeed be Kohn, and definitly Greenspan. As to the Bernanke has a monopoly on Great Depression causation, well that is just another broken myth. The important work has been anything but

  14. roger

    It is funny that the New Keynsians take out of Keynes his essential innovation, which was to jettison Say’s law. Markets don’t automatically clear. Equilibrium, in the real world, doesn’t happen. Which is the reason that Keynes was not worried about positive government intervention in the economy – that is, interventions that went beyond fiddling with taxes to create “incentives” for behavior.

    That the New Keynesians toss this out is much like New Galileo-ians tossing out the idea that the earth moves around the sun. But such is the state of economics.

  15. Richard Kline

    *ahKahKahKahK* That noise you hear is me, alternately screaming and eating strips of wallpaper off the vertical surfaces. Disuphonia, brought on by exposure to the thought processes of (some of) my fellow man. Soo the ‘advantage’ of DSGE as a model is that it allows the ‘analyst’ to exclude from consideration every observable process trajectory which might _conflict_ with the model’s performance. . . . Riiighht! If you try that as an individual behavior, the correct diagnosis is mania. Too right.

    The term ‘dynamic’ has real utility, but not the way it is used for this model. I wish I had an alternative prescription to Munchow’s, but in many respects I do not. For the economy as a whole to reach a more sustainable state, not to call it an equilibrium but one could mislabel it as such without too great a distortion, the outcomes he proposes will have to come into force. I think more could be done to mitigate income loss and asset price decline for the public by promoting cushions such as a more cost-realistic health care system and a reduction in wildly unfunded military expenditures—but I don’t expect to see those policy prescriptions implemented in the near term, either.

    Andrew Teasdale: I am in agreement wholly with your comments. Greenspan in particular realized, with some accuracy mind you, that by choking off most money supply he could stall out a wage-price spiral because the _real_ money in the economy was in preferential access to credit, which only the executive suite in corporations could use. Corporations could throw their books on the bargaining table showing that they didn’t have the money while using their corporate name to borrow their bonuses and ‘action money’ after forcing wage concessions. Tight money supply also keeps peon labor more dependent upon their bosses. When the Democrats in the US didn’t object to any of this, we had the effective merger in the US into the default one-party system on economic policy. As of today, we still only have Republiicrats running for office. St. Alan then took the view that he could allow credit to bloom and fade without having to worry about collateral damage from infllation. —But the ‘advantages’ would flow only to the bosses, not to the workers. Nifty, huh? Not.

    And this lable of ‘New Keynesians,’ look most of what Keynes actually thought and proposed has been _discarded_ but the modern ilk; they only keep the pieces which fit their pies, as comments in this thread alone point out. We have not seen any return to Keynesian advocacy by neo-liberal economists, or anyone else. Rather, we have seen a reformulation of stimulative policies carrying old but inaccurate placards. One might better call this new lot the Bloomers, for they want rates and credit to blossom growthlets without understanding that algae is what grows best in hot house conditions. Which sucks the oxygen out of the pond, suffocating everything else, to complete the analogy. One must study systems _as systems_; it’s hard and little understood work. Making models of systems which discard most of the information is in fact making models on the inside of ones own head. And as they say there, it’s GIGO.

  16. Richard Kline

    Further thoughtlets: I am quite glad to see Munchau emphasizing that not only are major economies presently operating in negative real interest rate territory, some of them have been for ’15 years’ as he says, or longer in various definitions and places. This is a salient fact I only wish to see brought home to the public and policy makers firmly at present. Any further prescriptions about where do we go from here have to incorporate salient facts about where we are now. And neg real rates are mighty salient. M.’s using his column to push that knowledge is a plus, as the US MSM just can’t get its head around this reality.

    Regarding the reserve currency: Changes in the reserve currency status most typically seem to happen not by choice or when they are ‘expected,’ but as a function of circumstance. I’ve covered some of that ground in comments months back, so I won’t bore anyone with reiteration. But consider this: If and when those $ pegs go, as many are presently advocating, the $ likely collapses as a reserve currency. Think it through and you’ll see what I mean. Our economy is on a cyclical decline, we haven’t begun to see the worst. Our capacity to make more money in the near term is linked to exports, the sweet spot of which are commodities, not manufactures, which many see as price-inflated; it will take time to ramp up genuinely profitable value-added exports. We have huge external debts. We have huge unfunded internal debts and a fiscal policy geared to increasing them ad infinitum. We have severe present neg real rates and a massively damaged banking system. What is holding the $ _UP_ at present are public capital inflows from the peggers trying to preserve their present macrofinancial strategies. The pressures on them ease if they let go the pegs, but they have to reweight their strategies. —Which is where this paragraph began, with the designation of a reserve currency. If and when the peggers decide that some other coin pays them better, then we get ‘destructive creation.’

    It would be well if China bashers and Oelogopolitan denouncers understood this situation. An internationally negotiated revaluation and coordinated policy environment would be in everyone’s interest, and the only way that reserve currency status for the $ will be maintained over the mid-term (15-30 years out). Will we get that?: Naw, I don’t think our present set of global policymakers have it in them. So we are more likely to get a conditional shift in the reserve currency in my view.

  17. Anonymous

    I certainly understand why politicians would not accept a drop in output of 13.5%, but I do NOT understand why everyone else seems to think so, too.

    Let’s make it even worse and imagine a loss of output equal to the drop between 1929 and 1933: in other words, a Great Depression II.

    Between 1929 to 1933, the U.S. economy lost roughly 29% of its per-capita output (in constant dollars). Applying that same percentage to today’s output puts us at the per-capita output level of 1988.


    As I recall, most Americans were feeling pretty good about 1988.

    Now, I realize that GDP is not the be-all-end-all of economic health. But wealth-redistribution can certainly help those at the short end of the 29% loss-of-output stick. And with Democrats likely to control both the Executive and Legislative branches come 2009, I don’t see wealth-redistribution being that big of a problem.

    So, once again, why does everyone think that this is such a disastrous outcome?

  18. Anonymous

    Richard Kline & Independent Acct.,

    “the $ likely collapses as a reserve currency”

    Does this mean gold will reassert itself as a store of value? IA, you allude to this; could you please elaborate?

    Bracing commentary by all!

  19. Richard Kline

    To Anon of 7:00 PM, there are a lot more of us in the US now than in 1988. So returning to 1988 levels, a completely arbitrary assumption BTW would involve a much bigger per capita drop than you are considering, even excluding the additional relevant fact that income distribution in the US in 08 is much less equal than in 88.

    To Anon of 9:21, I think it unlikely that gold will serve as a store of value unless the banking system is kaput or excludes a large number of participants. That is one reason why gold _has_ been a store of value in S Asia and the Near East, the banks were bad, especially with regard to some ethnic groups or classes. I do believe that in the US we will get a functioning banking system. We may have a bumpy path to this, but it will be a very high priority for those in a position to achieve it. So no, gold will not be money again here anytime soon if at all: it’s a speculative play. If the reserve currency ceases to be the dollar, we will still have dollars but their place internationally will be quite different. The reserve currency simply becomes another currency, perhaps even one that doesn’t exist yet, which is a long conjecture. More likely the euro has greatness thrust upon it, that’s how this happens. Yes, yes, there are real obstacles to this: no unified bond market in the Eurozone, no single regulator, etc., etc—bunk and null. If non-Europeans hold euros as their currency of account and hedge, than it is a reserve currency, period. The designation is functional, not ritual. The dollar might recover, but not in the same way. But consider a reality where Americans might choose to hold second accounts denominated in another currency, notably the euro. Is that such a bad world? For the wealth class in the US and the US government, yes; for the rest of us not necessarily.

  20. Anonymous


    One of us has not read carefully enough. The 29% output drop, as I mentioned, is PER-CAPITA. Perhaps I read the statistics incorrectly, but I don’t think so. Is your opinion still the same? I did also mention that income distribution could be remedied with a Democrat sweep.

  21. Anonymous

    “New Keynesianism ” is Blanchard, Romer, Mankiw.

    Those names look familiar? The normal world doesn’t associate these people with Keynes, but with the depredations and de-regulation of neo-liberalism.

    And of course, that’s what “ignoring credit/broad money supply” was really all about, deregulation.

    Munchau hopes to imply by using the term that we need to go back to some Friedmanite golden age, when it is the Friedmanites who created the current problems. That’s pretty annoying.

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