Being more of an empirical bent, I do not generally indulge
in the analysis of macroeconomic theory as thinking about it often causes me to
recall what I think was a quote by John Kenneth Galbraith something to the
effect that “Macroeconomics is like a religion, nobody truly knows what comes
in the hereafter.” More to the
point, I have to admit I find modern macroeconomic theory, policy and schools
of thought rather confusing having been raised in an undergraduate world where it was
simply Keynesian and Classical but I digress. Yet my curiosity has been piqued,
first by Nick Rowe’s January 1st blog piece “My simple theory about
why macroeconomists disagree” and then today’s piece by Paul Krugman on
“Ideology and Economics”.
I suppose that when one looks at whether there is agreement
or consensus amongst macroeconomists and views of the business cycle, it helps
to factor in the role of ideology or economic philosophy. I recall the classic first year text by
Parkin and Bade that helped me put this into perspective with the view that
when it comes to the role of government and economic policy, economists could
generally be classified as either “activists” or “passive”. Activist economists were generally
comfortable with discretionary government intervention in the economy because
markets were seen as often characterized by market failure and therefore
government could have a positive role in setting the economy straight. Passive economists believed markets
generally worked well, and therefore the role of government should be to
provide frameworks and policy rules rather than discretionary interventions,
which would either destabilize the economy or be ineffective at best.
Taking this basic continuum, one can then factor in the role
of fiscal and monetary policy. If
you are an “activist”, then both of these tools can be effective in addressing
an economic downturn though there may be debate as to which might be more
effective. If you are a “passive”,
generally you would not advocate fiscal or monetary discretionary intervention
but would stick with a more rules based approach and wait for the economy to
recover. Let me put this all in a
simple four-quadrant diagram with the continuum between “activist” and
“passive” on the vertical axis and the continuum between “monetary” and
“fiscal” policy on the horizontal axis.
Despite my earlier reference to macroeconomics as a religion, the fact
the diagram looks like a cross is purely coincidental. Let’s call it the macroeconomics policy
cross or MPC.
So with this MPC diagram, can we classify the various
approaches to macroeconomic theory and policy? Well, I’m not sure if I can but let me take a stab at
it. I would place old-style
Keynesians firmly in quadrant II – they are activist and firm supporters of the
use and effectiveness of fiscal policy.
I would place classical economists in quadrant IV – they are definitely
passive as to the role of government policy and I think their approach to
monetary policy would also be firmly passive. How about everyone else? A monetarist? I think quadrant IV.
If you are a “saltwater” macro-economist, I think you would be in either
quadrant I or II though the ultimate location would depend on views regarding
the efficacy or importance of monetary and fiscal policy. I would place them in quadrant II but
close to the border with quadrant I.
“Freshwater”economists? In either of quadrants III and IV but I think
more in IV. Real business cycle
theorists? I think a IV.
Anyway, in studying disagreements amongst macroeconomists,
I’m sure we will also disagree on how to classify them. However, my point is that while macro-economists
strive to be scientific in how they analyze issues and their focus on evidence,
they are also shaped by assumptions in how they approach empirical phenomenon
that reflect their economic philosophy or ideology even if they choose to refer
to it as theory. A macro-economist
who is fundamentally activist in outlook will have views and policy prescriptions
that differ from an economist who views the world from a passive perspective. The world and by extension the macro economy
are of course complex, with issues that require both activist and passive
responses. The real trick is to
know when to be an activist and when to be passive in your policy response. That part is a real skill and requires
the intuition of an artist.
Worthwhile Canadian Initiative 
While classicals would want a passive response, the mere fact of being in a situation that cannot exist according to their theory indicates flaws in the framework and policy rules that would require intervention, so you might want a third dimension, active in discretion vs active in systematics, though I am not sure classicals aren’t really closeted rbc types.
Market Montarists are Quadrant I.
“While classicals would want a passive response, the mere fact of being in a situation that cannot exist according to their theory…”
You think classical economists were unaware of downturns?! Or that their theory said downturns could not exist?!
They have no explanation of them other than shocks and are unable to explain why they might persist. Even shocks are mysterious since it presumes the economy is slower at responding than shocks occur.
Imagine an economist who thinks that monetary policy is sometimes (or usually) ineffective, and so favours the use of fiscal policy, but also has concerns about discretionary policy generally and thinks that a rule-based macroeconomic policy is best. He favours measures like automatic stabilisers or rule-based funding operations to affect the money supply through the fiscal credit channel i.e. switching from borrowing from the non-bank public to buying from banks.
Would this hypothetical economist be a prime example of quadrant III?
Also, to link to Ritwik’s blog post on classifying macro for the 500th time (but maybe the first time on this site) –
http://ritwikpriya.blogspot.co.uk/2010/01/macro-cube-1.html
– I think it helps a lot.
@W. Peden
Thanks for the link to the Ritwik Blog. Wow, a Macro Cube for classifying macro. I feel pretty two-dimensional with the macroeconomics policy cross.
As for your hypothetical quadrant III economist, sounds like a good fit. What should we call him or her? A fiscal rules passivist?
I worry sometimes about talking too much because I can come across as a rude and arrogant bastard sometimes. But I suppose some things need to be said…..
None of this matters in the real world (i.e. outside of university departments). Looking at various forms of macroeconomic theory I suppose as as useful as looking at various forms of Trotskyism, but it’s totally detached from anything that really matters outside of getting into a journal and getting tenure….
Let me explain why and it has to do with the nature of truth……
If you have no objective means of telling which theory is the truth, then how do you decide what to believe. If theory A says that the sky is green and theory B says that the sky is blue, then you choose theory B. However if theory A says that the sky is blue and theory B also says that the sky is blue, then you can’t use objective fact to decide between the two. So how do you choose?
OK. Theory A says that the sky is blue, but that you are a wonderful person and you deserve to make a million dollars a year and people who say otherwise are idiots and losers and should be ignored. Theory B says that the sky is blue, but you are a rotten scoundrel, and by the way you deserve to have your salaries cut, and people spit at you.
Now which do you choose? Of course, you choose theory A, and you give tons of money to professors that support theory A. Professors that support theory B don’t get invited to parties. They get less money. They don’t end up in talk shows. After a while they don’t have time to write papers or do anything else useful and no one hears about them.
Now it may seem dishonest to choose a theory based on personal self-interest, but if there is no obvious objective way to choose between two theories, then what else are you going to do? You choose the theory that makes you the most money and gets you the most stuff, and that works….. Until something happens that causes you to potentially lose all your stuff….
The thing about academics that favor zero government intervention is that for most people in finance, they ended up being both clueless and useless. Because the primary role of those professors was to be “useful idiots” and to write papers that said that bankers should make a ton of money, when the disaster hit, they in fact had no good ideas for how to fix the problem, and turned out to be utterly clueless about what was going on. Now they are not useful even as “useful idiots.” One nice thing about papers that are full of partial differential equations is that they look impressive to people that don’t understand PDE’s. So in 2000, you have a banker that wants to make more money, they get a professor that writes a paper that says that bankers should make more money, it’s full of PDE’s. Ohhhhhh…… Lot’s of complicated math, and pretty equations, you must be smarter than me, so I’ll accept your paper’s conclusions, here is the bonus check. The trouble is that in 2010, this won’t work.
Bankers in 2013 are just as greedy, selfish, amoral, and hypocritical as in 2003. The difference is that in 2007, they almost say all their wealth burn to the ground. In 2003, bankers wanted theories that promised bigger bonuses. In 2013, the big concern is that the office doesn’t burn to the ground again.
Before 2007, academic professors were useful at coming up with theories that said that bankers would make more money and as marketing shills. After 2007, they aren’t useful for that. Also since most of them seem to argue that there was no fire, they aren’t useful for keep the system from burning to the ground. So from a point of view of raw, personal, self-interest, no one with power outside of academia really cares what they think.
Academia is a self-contained world in which power and status are determined by journal articles and credentials, so if you trying to get tenure and journal articles published, these sorts of arguments matter, but if your goal is to convince anyone that is outside of a university, they really don’t.
Again, there is a basic philosophical issue here. What is “truth” and how do you determine it? If there is an agreed external mechanism for determining “truth” then we can use it. However, if there isn’t one, then you really have no alternative but to determine “truth” through self-interest and psychology. A lot of this is based on group dynamics. You accept as true whatever your social peer group accepts as true because if there is a fundamental conflict, you must leave that group. If you have a situation where there are no strong social constraints, then you accept as “true” whatever is in your personal self-interest. In 2003, classical neo-liberal economics was accepted as “true” because it made a lot of powerful people a lot of money and power. In 2013, that’s just isn’t happening.
There is a strong anti-tax and anti-government movement in the United States, but these sorts of movements also tend to be extremely anti-hierarchy so university professors don’t have much power in those movements. Also, once you figure out that these sorts of arguments can’t be resolved by “pseudo-physics” methodology, you start looking at other mechanisms to explain what is going on, and those include psychological, historical, and philosophical inquiries. History is particularly important. You may not be able to resolve the argument, but at least you know why people are arguing.
For example, the difference between “saltwater” and “freshwater” economists is just the tip of the iceberg of a long standing fight between agarian, rural, agricultural, Mid-Western interests and urban, banking, merchant, East Coast interests. If you were to resurrect the candidates of the 1896 election (William McKinley and William Jennings Bryan) they’d probably have a good laugh because people are arguing over the same issues that defined that election, although ironically the positions have reversed. In 1896 agarian interests wanted soft money whereas commercial interests wanted hard money, and today its the reverse.
Livio Di Matteo,
How about a “Rules Keynesian”? I think it’s significant that you’d need Keynesian liquidity-trap-style theories (either a circuitist theory or a ZLB-type liquidity trap would do) in order to get into such a theoretical position; otherwise, scepticism about discretionary policy implies a kind of monetarism.
Tim Congdon has a good chapter in “Keynes, the Keynesians and Monetarism” called “The Political Economy of Monetarism”, in which he argues that a key motivation for monetarists like himself is a scepticism towards discretionary policy and the fact that fiscal policy & the apparatus of (old) Keynesianism in general like incomes policies lent themselves towards discretionary policies. So a monetarist macroeconomic regime has benefits for anti-interventionists that can’t easily be demonstrated in a model. By omission, this is an interesting insight that scepticism about the efficacy of fiscal policy for demand management WASN’T a big motivator behind monetarism in the UK and this helps to explain why much of the post-1979 British macroeconomic policy regime involved attempts to control the money supply through what was basically fiscal policy.
This difference between monetarists and Keynesians persists to this day. New Keynesians are generally less keen on discretionary policy than Old Keynesians, but I think a lot of the difference between Paul Krugman and Scott Sumner on macroeconomic policy can be put down to differing attitudes towards discretionary policy. This helps to explain why quadrant III would be basically empty if you tried to place macroeconomists in each quadrant. (Though I suppose I’d go there if anyone could present a convincing argument for the ineffectiveness of monetary policy, but then again I’m not an economist and, a fortiori, not a macroeconomist.)
The other thing is that if people are arguing over “what causes the business cycle?” I think that’s the wrong question since there is a strong argument to be made that “business cycles” do not exist. The financial collapse in 2007 was a one time event that had never happened before in the history of the universe, and if we are lucky nothing like it will ever happen again. Also 2007 was so destructive, that it can’t be part of a cycle. If we mess up and something like 2007 happens again in the next decade, then it’s the end of capitalism, so it just can’t be seen as part of a cycle.
It doesn’t make any sense to me to see the collapse to be part of any sort of “cycle.” If you go before 2007, then you have a period of history in which there was one small recession in 2001, but nothing else before 1991. So if you take the period of economic history after 1991, its really hard to see anything “cyclic.”
I think the problem is illustrative of the “philosophical straitjacket” that macroeconomics has gotten itself into. In other threads people are complain about the lack of data. What do you do if you have only 100 data points. With things like the financial crisis, it’s worse, because you have only one data point. In order to use “pseudo-physics” methods you have to have multiple data points and that makes you wish for “cycles” since having “cycles” means multiple data points. However, you run into problems with this if reality just doesn’t cooperate, and you run into real problems if you aren’t aware of these limitations.
There’s no reason to think that the crash of 2007 and the subsequent events are part of a “cycle” and there’s no good reason to think that the dynamics of 2007 are similar to that of say the recession of 1991. In fact there are good reasons to think otherwise. Derivatives played a huge role in 2007, and those derivatives would not have been possible without cheap computing power and the internet and those didn’t exist before 2000. Cheap computing power and the internet fundamentally changed the nature of finance and the financial system after 1995. The heavy use of derivatives and mortgage backed securities would simply not be possible without fast computers, and one reason things spread quickly in 2007 is because the entire financial system is linked by the internet in a way that wasn’t true in 1991 or even in 1995.
The critical role of technology means that you just can’t simply put what happened into a general theory of the business cycle, and if macroeconomists want to say useful things they just have to change their theories to handle “one time events.” Fortunately, there are a lot of other fields (i.e. economic history and cosmology) that handle “one time events” but that requires different modes of analysis. For example, the invention of the internet is a one time event, however a dramatic improvement in communications technology is not, so you can probably gain some insight how the internet influenced the financial crisis by looking at how the telephone impacted the Great Depression or the telegraph influenced the crash of 1873.
If you want to ask me. What the root cause of 2007 was that for a brief moment, technology advanced so that for a brief moment, the financial controls that people had developed over the last hundred years got circumvented. The pre-2007 financial regulations were designed for national markets, and the internet has created one global market.
Also the events since 2007 has made a lot of macroeconomic theory sort of irrelevant, because the solutions that are presented are often too abstract and vague to be useful. For example, if the advice is “open markets” and “reduce taxes” you have to realize that those can take months if not years to implement, and they are often irrelevant when you have days or even hours to do something. Talking about public spending policy isn’t that useful when you are in the middle of fighting a fire and keeping a house from burning down. Even after you have the fought the fire, the type of policy you are interested are specific detailed implementation ideas. General debates about more or less government are not useful and are likely to be ignored.
Twofish,
I prefer Milton Friedman’s (violin) “plucking” metaphor alternative to the cycles metaphor: economies generally follow a very steady longterm trend, but occasionally get plucked above or below this trend, before unsteadily returning to it. So you get booms with gentle comedowns (like the slowdown after the late 1990s boom) and busts with slow recoveries, because the causes of long-term growth rarely vary and dominate over other factors as the effects of the initial pluck play themselves out.
Nick,
Your statement:
“Activist economists were generally comfortable with discretionary government intervention in the economy because markets were seen as often characterized by market failure and therefore government could have a positive role in setting the economy straight. Passive economists believed markets generally worked well, and therefore the role of government should be to provide frameworks and policy rules rather than discretionary interventions, which would either destabilize the economy or be ineffective at best.”
The ability for a central bank to conduct monetary policy is given to it by a government. And so your chart is a bit misleading because it assumes that monetary policy and fiscal policy are totally independent of each other.
Simple example – a government wants to borrow money but the private markets do no want to lend the government money. Can the “independent” central bank of the government chose to not lend the government money?
@Frank
That’s a good point regarding the fact that monetary and fiscal policy are not totally independent of each other. Not sure how else to draw the chart to take this into account.
Livio,
First, consolidate both monetary and fiscal policy into one heading. Then separate the government’s financing decision from its spending decision:
Monetary / Fiscal Policy
Financing Decision Spending Decision
Taxation Goods
Debt Transfer Payments
Equity Settlement of Debt / Equity Claims
Livio – Text did not align properly
Monetary / Fiscal Policy
Financing Decision – Taxation, Debt, Equity
Spending Decision – Goods, Transfer Payments, Settlement of Debt / Equity Claims
Twofish,
Why was 2007 unique, because of derivatives and asset-backed securities? Are those really the defining characteristics of the 2008 crash, or they just the latest variation on an old theme, namely leveraged assets bubbles. Certainly on a lot of levels there are remarkable similarities between the 2008 crash in the US (or Spain or Ireland), the Japanese cash of 1989 (to which current policy makers are looking for advice on what not to do to recover from the current crash), and the 1929 crash (we tend to think of the great depression as being triggered by the stock market bubble, but it’s worth recalling that the 1920’s also witnessed a spectacular leveraged real estate boom and collapse).
At most you might say the new technologies and larger markets make it possible for people to rationalize making the same mistakes as previous gemerations relying on the “this time it’s different because of technology/globalization/innovation (pick your rationalization).
In the 2000’s bankers convinced themselves that “this time was different” on the basis of innovative new securitization structures and the alleged AAA rating of MBS. In the 1990’s investors in tech stocks convinced themselves that record high P/E ratios weren’t a concern because “this time is different” because of technology. Go back far enough, there were probably dutch investor telling themselves that “this time is different” because tulip bulbs were new and different. In each case the new technology/innovation didn’t cause the crash, it just make it easier to rationalize repeating the same mistakes.
Frank Restly
“And so your chart is a bit misleading because it assumes that monetary policy and fiscal policy are totally independent of each other.
Simple example – a government wants to borrow money but the private markets do no want to lend the government money. Can the “independent” central bank of the government chose to not lend the government money?”
Perhaps not, but provided the central bank can still set the rest of its policy independently, it can create crowding-out by tightening credit to the private sector. In this respect, fiscal policy is just another event that has to be factored into monetary policy decisions, like a productivity boom, an asset price bust or a regulatory change.
W. Peden,
Private credit is an agreement between a private bank and a private individual / group. A central bank is not directly involved in that decision. It can set reserve requirements for its member banks and it can set interest rates by buying and selling government debt, but ultimately it is not in the job of rationing credit.
I would like to sound the same horn as Bob Smith,
2008 was just the same bubble bursting recession as so many before. And it will happen again and again. Long growth periods, with easy low credit at the end, just the “this time its different” arguments a little different each time.
The 1991 and 2000 cycles were shallow, due to the Greenspan lowering interest rate mantra, making for a more severe 2008, as sure as the sun is rising tomorrow, 8:07 local time.
I see the same real estate (beton)gold rush starting now here in Germany, prices have risen by 20% last year, actually have to rise some 20 – 30% more to provide enough incentive for a lot more construction getting started (we underbuilt the last 10 years) but to pierce this bubble in time and controlled, I see as a test of our political and economics maturity. In 4 years from now, we should know : – )
Most people here consider monetary shenanigans like NGDP as tricks of the giant vampire squids, and their helpers. And active vs passive depends on the details of the special question.
Frank Restly,
Nothing I said implies that central banks are DIRECTLY involved in rationing credit. What is true of the individual case is not necessarily true of the system as a whole.
The central bank cannot help but be in the job of rationing credit, because in a monetary economy credit is credit for base money and the central bank has the power to expand or contract base money and in doing so it alters the structure of assets in an economy. To preemptively head off a strawman that I know you weren’t going to bring up, but someone else might: the central bank intermediately targets interest rates, but interest rates are a target rather than an instrument.
So if a government borrows from the central bank in a way that threatens the central bank’s final target, it can raise its intermediate interest rate target, putting its operations onto a new path and changing its influence on private credit expansion, thereby crowding out private borrowing.
W. Peden,
“So if a government borrows from the central bank in a way that threatens the central bank’s final target”
If the central bank is targeting a nominal interest rate, then no amount of government borrowing will preclude the bank from hitting that rate. It is only when a central bank targets a real (inflation adjusted) interest rate that monetary policy must factor in fiscal concerns.
Frank Restly,
I agree on your first sentence. I’d extend it to all nominal variables: an independent central bank can alter monetary policy to offset any fiscal effects on nominal variables. (The Sumner Critique.)
I might agree on your second sentence. What do you mean “factor in”?
I don’t often agree with genauer, but has been said elsewhere that it is hard to miss the similarities between 2008 and 1929. They bear the unmistakable signs of being siblings; both were credit crashes, both involved real estate, both resulted in demand deficiencies and both resulted in interest rates knocking up against the ZLB. I said in 2008 that we had not been in a low-rate recession since 1929 in Canada.
1981-82 and 1991-95 in Canada were high-rate recessions; as Torben Drewes (an economist at Trent) said, those were “planned” recessions, the Central Bank caused them to cure inflation. 2008 was “unplanned” and we hadn’t seen that in a very, very long time.
W. Peden,
“I agree on your first sentence. I’d extend it to all nominal variables: an independent central bank can alter monetary policy to offset any fiscal effects on nominal variables. (The Sumner Critique.)”
I would disagree with that sentence. Monetary policy cannot offset fiscal policy when fiscal policy has a destructive objective. Can monetary policy replace lives lost?
“What do you mean factor in?”
I meant that governments don’t borrow to fund production – hence their borrowing is decidedly tilted toward funding consumption.
Bob Smith: Why was 2007 unique, because of derivatives and asset-backed securities?
The trigger for 2007 was not unique, but we’ve had a lot of asset bubbles before. But since 1929, we’ve never had a situation in the developed world where the bubble was severe enough to cause the institutional foundations of the economic system to collapse. We were probably at most three days (and perhaps hours) from a total financial meltdown. Yes there have been “regional crashes” but no global crash since 1929.
Modern banking involves the ability to rapidly convert assets from one form to another. You go to an ATM, withdraw X dollars, go to a store, and the convert that money into goods and services. What happened when Lehmann collapsed was that system came very close to totally breaking down. This hasn’t happened since 1929. The economic system is one giant video game in which money consists only of electronic scores and nothing else. If you run into a situation in which the numbers have no meaning, then you have the sort of meltdown that we had in 2007.
Bob Smith: In the 2000’s bankers convinced themselves that “this time was different” on the basis of innovative new securitization structures and the alleged AAA rating of MBS.
And I would argue that it was different. Just not different in a good way. The problem with the innovative new securitization structures is 1) that they had the effect of bypassing the regulatory controls that had been developed since 1929 to avoid a big crash and 2) because a lot of this bypassing involve globalization, what happened was that you had a global crash rather than a national one.
You can compare what happened in 2007 to the Japanese bubble in 1989 and the US S&L crisis of the mid-1980’s. But in both cases the crash was localized. It’s informational technology that caused both the boom and bust to be global.
Bob Smite: In the 1990’s investors in tech stocks convinced themselves that record high P/E ratios weren’t a concern because “this time is different” because of technology
Some things are different. Some things are the same. Human nature hasn’t changed in several thousands of years, but technology changes the consequences of human nature.
That’s what makes things difficult is that you need to figure out what is different and what is the same. Also different is not necessarily good. The stock market today is fundamentally different than it was in 1990. Most stocks are traded by computers today/
But what was different when it comes to the business cycle is the use of technology to adjust interest rates. In the 1970’s, the basic interest rates was the prime rate, and that got adjusted once every few months. Since the early 1990’s, the basic interest rates get adjusted on a daily, even hourly basis. If you think that the business cycle is due to “mismatch of information” one would expect (and one did see) that recessions essentially disappeared since 1991.
genauer: 2008 was just the same bubble bursting recession as so many before. And it will happen again and again. Long growth periods, with easy low credit at the end, just the “this time its different” arguments a little different each time.
It wasn’t. In 2008, we were at most a week from a situation in which you start seeing bank collapses and all your credit and ATM cards stop working. This hasn’t happened since 1929. Now because people moved heaven and earth, what ended up happening was a “normal recession” but that involved a ton of effort.
What happened in 2008, can’t happen again, because the entire world financial system came within a hairs breath of becoming non-functional (i.e. your money becomes worthless). If anything like it happens again, then we are seeing the end of market economies.
One thing about this is that “I was there.” One reasons some academic economists have very little credibility in the financial industry is that they insist that what happened in 2007 wasn’t unusual. If you get rescued from a burning building, it’s hard to think highly of people that think that it wasn’t such a big fire.
Boom-bust cycles are not new. What is new is a bust that wipes out the global economy. I don’t think it would have been as bad as it was without the internet, because the internet links global economies so that something that blows up in one place spreads everywhere within hours.
genauer: 2008 was just the same bubble bursting recession as so many before. And it will happen again and again. Long growth periods, with easy low credit at the end, just the “this time its different” arguments a little different each time.
It wasn’t. In 2008, we were at most a week from a situation in which you start seeing bank collapses and all your credit and ATM cards stop working. This hasn’t happened since 1929. Now because people moved heaven and earth, what ended up happening was a “normal recession” but that involved a ton of effort.
What happened in 2008, can’t happen again, because the entire world financial system came within a hairs breath of becoming non-functional (i.e. your money becomes worthless). If anything like it happens again, then we are seeing the end of market economies.
One thing about this is that “I was there.” One reasons some academic economists have very little credibility in the financial industry is that they insist that what happened in 2007 wasn’t unusual. If you get rescued from a burning building, it’s hard to think highly of people that think that it wasn’t such a big fire.
Boom-bust cycles are not new. What is new is a bust that wipes out the global economy. I don’t think it would have been as bad as it was without the internet, because the internet links global economies so that something that blows up in one place spreads everywhere within hours.
Some things are the same. Some things are different.
I do think that the crash of 2008 resembles the crash of 1929 and a lot of the 19th century banking panics. This is unusual, and I think it was because the internet technology of the 1990’s allowed financial institutions to circumvent the rules that were intended to prevent a repeat of 1929.
The crash of 2008 was also different from 1929 in the speed. 1929 led to a global depression because banks started collapsing the months after stock market crash. In 2008, you had banks starting to wobble in a matter of hours, and if the central banks had not stepped in, the entire banking system would have collapsed. One thing that people have to realize is that money is just one big video game with dollars being your score, and we came very close to the point where the plug got pulled and the numbers just go “poof.”
I was in the middle of this, so I was seeing this first hand. Oddly enough, everyone was pretty calm, because everyone was just so busy.
You have waves hitting the shore every few seconds, but a tsunami is more than just a big wave.
Peden: I prefer Milton Friedman’s (violin) “plucking” metaphor alternative to the cycles metaphor: economies generally follow a very steady longterm trend, but occasionally get plucked above or below this trend, before unsteadily returning to it.
I think that’s a good metaphor, but I’d like to add one more and that is that what made 2007-2008 different was that the string got pulled so hard that the string broke. Once the string breaks, then you are following totally different rules.
Right now what people outside of academia are more interested in is how to keep the string from breaking in the future. Also once the string breaks, then things are different even if you repair it.
Frank Restly,
“I would disagree with that sentence. Monetary policy cannot offset fiscal policy when fiscal policy has a destructive objective. Can monetary policy replace lives lost?”
Lives are a real, not a nominal, variable.
“I meant that governments don’t borrow to fund production – hence their borrowing is decidedly tilted toward funding consumption.”
I think I see and agree. Would I be representing your fairly if I said that what you are saying is that fiscal policy can affect the composition of GDP, and monetary policy can’t offset this compositional effect?
Right now what people outside of academia are more interested in is how to keep the string from breaking in the future. Also once the string breaks, then things are different even if you repair it.
The thing for Canadians that casts our mind back to 1929 is that US banks were on fire, and ours weren’t. The US had thousands of bank failures in the 1930’s, Canada didn’t have any, it had two near-misses dealt with through our favourite strategy, Club Banker. This time around Club Banker included the Bank of Canada (we had no true central bank in 1929 but the Bank of Montreal came close) but the system was not experiencing undue strain from within. What pushed us over the edge economically was the collapse in trade and demand from the US.
Canadian dollar deposits and the clearing of Canadian dollar debt was fine.
But it did reiterate the point that there is no substitute for bank chairmen who seem themselves as bankers and behave as such. Aside from regulators, Canadian banks are all run by CEO’s who came up through the ranks and started in branches. They see themselves as bankers and that there is no substitute for moderation in leverage and high capital reserves. The Royal Bank had an investment banker as Chairman a decade ago and the experience was not positive for them.
Twofish,
Well, once you concede that “since 1929, we’ve never had a situation in the developed world where the bubble was severe enough to cause the institutional foundations of the economic system to collapse” or “I do think that the crash of 2008 resembles the crash of 1929 and a lot of the 19th century banking panics” you’re contradicting your previous position that the “financial collapse in 2007 was a one time event that had never happened before in the history of the universe” (unless, that is, the universe started in 1930). Which, I think, was the point that Genauer, Determinant and myself were making.
Can you give some examples of how you think that the internet (or other technologies) allowed banks to avoid the regulatory regimes introduced after 1929? That isn’t a thesis I’ve heard before and, frankly, it doesn’t sound all that credible.
“The crash of 2008 was also different from 1929 in the speed. 1929 led to a global depression because banks started collapsing the months after stock market crash. In 2008, you had banks starting to wobble in a matter of hours, and if the central banks had not stepped in, the entire banking system would have collapsed”
You’re not comparing like with like. The world banking sector didn’t collapse overnight in 2008, it was a long drawn-out process running well over a year. In 1929, the trigger for the banking collapse was the stock market collapse. In 2008, the trigger was the housing market collapse – and that started in 2007 (if not earlier).
While the collapse of Lehman Brothers in Septeber 2008 is often seen as the starting point for the 2008 crisis, it wasn’t exactly a secret that the world’s banking system was in crisis well before then. After all Bear Stearns collapsed in March of 2008 (and was taken over by Morgan Stanley) and Northern Trust was nationalized in the UK in February of 2008 (after having been bailed out by the Bank of Englang 6 months earlier). It’s true that the final collapse of Lehman Brothers occured over the course of a weekend, but it had been looking for possible white knights to take it over for months before its ultimate demise (notably negotiations with the Korea Development Bank in August 2008). Lehman Brothers (or Merrill Lynch or AIG or what have you) didn’t start to wobble in September 2008, they’d been wobbling for a year and only collapsed in Septebmer 2008. In that light, the circumstances of the banking crisis of 2008 don’t look materially different from those of say, the Barings crisis 118 years earlier. It isn’t clear that the speed of the latest crisis was any greater than those of prior crises.
Testing. Having difficulty posting here.
History doesn’t repeat but it rhymes. The American Revolution and the U.S. Civil War were one time events that had never happened before in the history of the universe and will never happen again. That doesn’t mean that you can’t understand the American Revolution by say comparing it to the French Revolution as long as you realize that there are differences.
As far as the role of the internet….. just one example….
It turns out that English law allows you to sell anything, but the regulate buying securities heavily. German law allows you to buy anything, but they regulate selling things. European countries regulate insurance companies pretty heavily at the national level, but US insurance regulators are at the state level and don’t coordinate with bank regulators. So you have an American insurance company, issue massive amounts of securities in England, sell them in Germany, and therefore bypassed every single rule on required reserves. People weren’t even aware that someone was doing this, because this bypassed every reporting requirement. Until the day after Lehman blew up, when it was clear that said company had put major policies on Lehman, and that it was about to sink the European banking system as well as the US and Asian insurance markets.
Bob Smith: You’re not comparing like with like. The world banking sector didn’t collapse overnight in 2008, it was a long drawn-out process running well over a year.
It’s like a blackout or a chemical plant explosion or a bridge collapse. Yes, the plant was on the verge of exploding for months and months, but once it goes up, it goes up fast.
Once the process started than everything was happening over the time scale of hours. The day after Lehman collapsed, every hedge fund and every major corporation was pulling money out of every single investment bank in the world. It was only the intervention of the Fed that stopped this run. The first week after Lehman collapsed was
literally an hour by hour effort to keep the system from falling to shreds and to get to the weekend. Things were happening on an hour-by-hour minute-by-minute timescale.
Also, we didn’t have a total banking financial collapse. A total banking financial collapse would be something in which everyone’s bank accounts would be wiped and people’s credit cards and ATM would be useless. We came scary close to that happening. Lehman pulled down the weaker banks, but once the weaker banks went bust, it would have killed all the banks.
Lot’s of things become more clear once you live through them yourself. One thing that really concerns me is that I’ve been shocked at the gap between practitioners and academics. There are some “obvious” things about the financial system (like the fact that your money is in cyberspace) that academics don’t seem to be aware of. Part of it was that politicians and business leader were playing down the crisis, since the last thing that people wanted was to have everyone go to their local bank and empty out their accounts, since that would have killed the system. (And there wasn’t nearly enough money in depositor insurance to cover a full scale in the US run until Congress passed a funding bill.)
I was in the building while it was burning. We can have a discussion of how the building caught on fire, and how it is the same or different than things were 100 years ago. However, you aren’t going to convince me that there wasn’t a fire, and that the fire wasn’t spreading very, very, very fast.
“The American Revolution and the U.S. Civil War were one time events that had never happened before in the history of the universe and will never happen again.”
That’s really a trivial statement, don’t you think? That’s true of everything in a universe were time flows in one way.
“So you have an American insurance company, issue massive amounts of securities in England, sell them in Germany, and therefore bypassed every single rule on required reserves.”
I presume you’re talking about AIG (though you might be more credible if you were less vague on the point). If so, I’m not sure what you’re talking about, because AIG blew up because it was writing unhedged CDS (which, theretofore, were not regulated anywhere), not buying and selling securities under different regulatory regimes. In any event, whatever you’re talking about, what’s that got to do with the internet? AIG wasn’t selling CDS to Frau Ubermann at swapmyrisk.com
I was in the building while it was burning. We can have a discussion of how the building caught on fire, and how it is the same or different than things were 100 years ago. However, you aren’t going to convince me that there wasn’t a fire, and that the fire wasn’t spreading very, very, very fast.
The problem wasn’t the internet, the problem was simple deregulation. In the US particularly, “near-banks” had grown into a very large grey area. AIG was one, money market funds were another. People used money market funds as bank accounts without any of the safeguards that bank accounts have. Institutional savers, like municipalities investing reserve funds put their money into Asset-Backed Commercial Paper when they should have simply stuck to Bank GIC’s. When I saved up the $13,000 I put down on my car, I went no further than GIC’s issued by the Bank of Montreal. People forgot that credit quality is important and that means reputation, not just rating.
I saw in 2007 that savings-quality instruments being revealed as risky would be a big, big problem. The inverted yield curve said as much.
Twofish’s account reminds me very, very much of the narrative of the 1985 bankruptcy of the Canadian Commercial Bank and the Northland Bank went bust, the first time that had happened in Canada since 1923. Bankers and lawyers had to relearn just what insolvency means for banks in law; they had to relearn lessons which had been forgotten for 60 years. Supposedly safe instruments such as bank drafts bounced and caused significant problems. The Government of Canada had to step in and guarantee the failed bank’s deposits 100% (over and above CDIC) and the Bank of Canada was forced to extend an emergency loan to enable the financial system to clear. That loan is still being written off on the Bank of Canada’s books.
I was thankful that the BMO never got itself into trouble.
Smith: That’s really a trivial statement, don’t you think? That’s true of everything in a universe were time flows in one way.
No it’s not. Newtonian mechanics is time symmetric and time-invariant and involve interactions with no history. Every electron is exactly the same as every other electron and every interaction between two electrons is exactly the same as every other interaction. This allows you vastly simplify models involving particles or billiard balls. That also means that Newtonian models are terrible metaphors for most economic situations.
Smith: . If so, I’m not sure what you’re talking about, because AIG blew up because it was writing unhedged CDS (which, theretofore, were not regulated anywhere), not buying and selling securities under different regulatory regimes.
Wrong. CDS’s are in fact very heavily regulated. AIG couldn’t for example sell CDS’s in the United States because as an American insurance company they can’t legally sell securities in the United States without SEC approval. However, US law doesn’t apply to sales in Germany. Similarly, they couldn’t sell unhedged CDS’s in either England or Germany because it’s illegal and the regulators would have shut them down for it. However, an US insurance company selling English securities to Germany over the internet was something that the drafters of securities regulations just didn’t think of.
Smith: In any event, whatever you’re talking about, what’s that got to do with the internet? AIG wasn’t selling CDS to Frau Ubermann at swapmyrisk.com
But they were selling billions of dollars in CDS’s to say Ubermann Land Bank over the internet. When a company buys financial instruments. What do you think they use? Smoke signals? Paper airplanes? Computer A sends an encrypted message to Computer B over an encrypted link on the internet.
The internet is particularly useful since it allows people to people to switch regulatory regimes. If I am in a office in New York and I had you a paper contract containing a transaction that’s forbidden under New York law, then the lawyers and the regulators will scream at me if I pull out a pen and sign. But I can pull out a laptop, send a message to a server in London or the Cayman Islands, and at that point the transaction happens under English or Cayman Island law, and if the transaction is not fraudulent, the SEC or US regulators can’t do anything because the transaction is not happening in the US. Extremely useful for selling derivatives which are heavily regulated under US law.
“Bankers and lawyers had to relearn just what insolvency means for banks in law; they had to relearn lessons which had been forgotten for 60 years.”
One of the upshots of which was that it lead to a Supreme Court of Canada decision which remains the leading case on the legal distinction between debt and equity – a significant consideration for a tax lawyer.
“People used money market funds as bank accounts without any of the safeguards that bank accounts have. Institutional savers, like municipalities investing reserve funds put their money into Asset-Backed Commercial Paper when they should have simply stuck to Bank GIC’s”
In fairness, beyond dergulation, part of what explains the rise of ABCP and other innovative financial instruments in the 2000s was the interest rate environment. The first half of the 2000’s was something of a wasteland for savers, with interest rates on low risk investments bouncing around all-time lows, and people still spooked from the tech bust of the first year of the century. GIC’s were safe, but if they don’t produce enough income to live on, that’s not terribly helpful. The people who, once upon a time, would have piled into government bonds, GICs, and savings accounts turned to all sorts of innovative (if not neccesary suitable, in their particular circumstance) yield-oriented investment products (think income trusts, ABCP, target funds, equity-linked GICs) in order to eke out a few extra points of yield. Not all of those turned out to be disastrous, but they all involved nasty surprises for investors.
Thinking about it like that, a low interest rate policy is a dangerous proposition, it encourages borowers to borrow more, while encouraging savers to pursue risker investments in pursuit of yield. Which, come to think of it, is exactly what happened. And things haven’t changed, we still have record low rates, and clever people are still peddling innovative new products to produce “yield” for retail investors and I’m certain that few of their potential investors appreciate the risks associated with those products. And Canadians, at least, are still borrowing like there’s no tommorow.
Determinant: The problem wasn’t the internet, the problem was simple deregulation. In the US particularly, “near-banks” had grown into a very large grey area. AIG was one, money market funds were another.
But this deregulation was caused by technology. In the 1960’s, the US could force people in the US to keep their money in US banks under US regulated interest rates. This broke down in the early-1970’s, when people figured out that they could put their money in London and get higher unregulated interest rates. At that point “money markets” were born.
Something that I don’t think most people get is that “shadow banks” aren’t some side thing. Shadow banks are the main banking system. The thing about changing laws is that it’s hard and painful. But what you can do is use new technology to circumvent the law.
Determinant: Institutional savers, like municipalities investing reserve funds put their money into Asset-Backed Commercial Paper when they should have simply stuck to Bank GIC’s. When I saved up the $13,000 I put down on my car, I went no further than GIC’s issued by the Bank of Montreal. People forgot that credit quality is important and that means reputation, not just rating.
I’m not familiar with Canada, but in the US there is an insurance limit, so if you have more than $250,000, you aren’t subject to government insurance. If you have extremely large amounts of money (say $25 million), what you do is to execute a repurchase agreement. You sell me US Treasuries and agree to buy them back in a week at a slightly higher price. If you go poof, I have your Treasuries, and can sell them for cash. There is a subtle risk. I may not be able to sell those Treasuries if all the banks go bust.
The other issue is that for large corporations, there’s no point in putting your money in a bank. You can “cut out the middleman” and buy and sell the things that the bank would have sold you. Again the internet lets you do it. Instead of buying things at the local store, you go to Amazon marketplace and you can buy direct. The flaw is if Amazon stops working you are sunk. You don’t owe money to Amazon, but if you depend on Amazon to buy and sell stuff and Amazon stops working, you are hosed.
To express that another way. I don’t own stock in the telephone company or the power company, so in principle, I shouldn’t care if the telephone company or power company goes bankrupt. If I think the telephone company is risky, I invest elsewhere. I might put my money in nice safe boring CD’s. However, in a crisis, if the telephone or power goes poof, and I can’t call anyone to redeem my CD’s, they my CD’s are in practice worthless.
That’s why the Lehman collapse was so destructive. It wasn’t just the idiots that were getting killed. Because Lehman was a critical piece of infrastructure, people who had all of their money in nice safe instruments realized that they may not be able to convert them to cash. So you go to the bank and pull out all of the cash now. This stopped when the Federal Reserve said, don’t worry, we the government will convert stuff into cash for you.
That’s why you would have gotten hosed even if you had your money in GIC’s. You put your money in GIC, the bank takes the money and invests it in safe boring stuff. If you want your money, the bank sells the safe boring stuff and converts it bank into money and gives it to you. If the bank can’t sell the stuff because the power goes out, then everything falls apart.
Something that I don’t think most people get is that “shadow banks” aren’t some side thing. Shadow banks are the main banking system. The thing about changing laws is that it’s hard and painful. But what you can do is use new technology to circumvent the law.
Not in Canada, they aren’t. The Big 5 banks are the banking system, the shadow banking system here is really shadowy, er, small.
Second, because Canada did not regulate interest rates like the US did, nor did we ever forbid interest on chequing accounts (the banks used to offer products like that in the 1980’s, they don’t anymore), shadow banking had little reason to grow here. Most Canadian corporations only have one banking relationship, they have no need for more. Banks here are integrated, they are securities dealers and trust companies (for assets) as well as banks. Moving up the food chain still means dealing with a bank, except the bank is now offering “Treasury Services”. Credit quality issues still mean you are buying bank paper or perhaps paper issued by the life insurers.
The CDIC limit in Canada ($100,000) does not really apply to the Big 5 banks; CDIC is actually a pro-competition measure to allow retail depositors to confidently deposit funds in small startup banks and small foreign (Schedule II under the Bank Act) bank outfits in Canada.
The OFSI, the bank regulator is frankly competent and between them and Canadian banks being the definition of “Widows and Orphans” stocks, there has been little pressure for bank CEO’s to be too enterprising or interesting for the bank’s good. Canadian banks hold 12%+ Tier 1 capital; OSFI rules state the minimum is 10% and 75% of that (7.5%) must be shareholder equity. Regardless of insurance, you have to go a long way to find better credit quality than a big Canadian chartered bank.
The fact that the last three bank insolvencies were the Northland Bank and Canadian Commercial Bank (1985) and the Home Bank of Canada (1923) should tell you something about how we do things here.
One trouble is that the interest rate environment encourages risky behavior on the part of banks. I go and buy a nice safe CD from a bank. If it’s government insured, I don’t care what happens next. What does the bank do? It has very strong pressure to invest that into risky investments. Once again, the internet strikes again. One thing that the internet does is to slice margins. Banks don’t care about the level of interest rates, they care about the margin and the flow. One thing that banks like to keep quiet was that 2009 was an excellent year for investment banking. People dumped all their assets and bought them all back, and that meant a lot of trading revenue.
The other thing is that if you think the world is going to end, risky behavior is rational. There was a lot of investment in Freddie and Fannie, and people didn’t care about the financial condition, because the belief was that if F&F were to go under, it would such a disaster, that the government would do a bail out, which is what happened. The nasty thing about financial crises is that it hits innocents, who then rationally wonder if they wouldn’t have been better off had they acted badly and irresponsibly. If you look at Latin America and Russia and inner cities, you see behavior that’s incredibly economically destructive but quite rational. Savings rates are extraordinarily low because savers got punished in the past.
Canada has a lot to be proud of. The system worked extremely well. The question that I think people are trying to deal with is how to apply this to a global system. One thing that fascinates me is that every country does banking in a different way, and often there are strong historical reasons why it has to be done in a certain way.
“But this deregulation was caused by technology. In the 1960’s, the US could force people in the US to keep their money in US banks under US regulated interest rates. This broke down in the early-1970’s, when people figured out that they could put their money in London and get higher unregulated interest rates. At that point “money markets” were born.”
That doesn’t follow. What was the technology that was introduced in the early 1970’s, which didn’t exist before that time and which allowed Americans to put their money in London? Could’t be the internet, that was still a gleam in Al Gore’s eye. Telephone and telexes? They’d existed for decades. The rise of the eurodollar market has different explanation (notably the fact that the US was pumping dollars around the world to pay for the Vietnam war ), but technology isn’t one of them.
long and the short: Canada modelled our banking system after Scotland’s. Bankers in Canada, historically, were often Scots.
Your point about GIC’s is misplaced. That’s where Tier 1 Capital comes in. Canadian banks have a massive capacity to take losses. Further, as 1985 demonstrated to Canadian banks and regulators, there is no substitute for adequate diversification both geographically and among business lines and that retail depositors, who are “sticky” are very much to be preferred rather than wholesale depositors who are “flighty”.
CCB and Northland got into trouble because they had poor, non-performing loans exclusively in Alberta; the price of oil crashed and Alberta’s economy went with it, it does that. Everybody in Canada knows that.
Here’s what Seeking Alpha said about Canadian Banks business models in 2009:
Second, the average Canadian chartered bank holds only 25% of its assets as residential mortgage loans, the remaining 75% spread between government debt, credit cards, personal lines of credit, business loans, and corporate bonds. That means that if one asset class plummets, or an industry flounders, odds are another will hold up.
http://seekingalpha.com/article/121945-why-canada-s-big-5-banks-won-t-go-bankrupt
That diversity is what allows Canadian banks to be such excellent financial intermediaries, even for large businesses. They just contract their cash management services to the bank.
Sigh…
My earlier response got eaten, so let’s try this one.
Twofish: “Wrong. CDS’s are in fact very heavily regulated. AIG couldn’t for example sell CDS’s in the United States because as an American insurance company they can’t legally sell securities in the United States without SEC approval. However, US law doesn’t apply to sales in Germany. Similarly, they couldn’t sell unhedged CDS’s in either England or Germany because it’s illegal and the regulators would have shut them down for it. However, an US insurance company selling English securities to Germany over the internet was something that the drafters of securities regulations just didn’t think of.”
Interesting use of the PRESENT tense in that statement. Because CDS were not regulated in the US in 2008. Don’t take my word for. Take the word of the Governor of New York who announced, on September 22, 2008 (Barn. Door. Horse) proposals to BEGIN to regulate CDS, using the state’s power to regulate insurance:
“The absence of regulatory oversight is the principal cause of the Wall Street meltdown we are currently witnessing… While I applaud the recent federal intervention to stabilize the market — and thus our entire economy — it is important we also take the next step as a nation by regulating areas of the market which have previously lacked appropriate oversight.”
Do you think he was comletely unaware of the regulatory framework for the SINGLE MOST IMPORTANT ISSUE ON HIS PLATE AT THAT MOMENT IN TIME? You can tell a similar story for the UK and Germany who, sure, banned naked CDS AFTER 2008 (Germany banned them temporarily in 2010, and the EU proposed a ban on naked sovereign CDS effective 2012. Again, are the Europeans completely oblivious to some existing regulatory framework?
Sure, the sale of securities is subject to SEC oversight. But since the SEC took the position in 2007 (based on amendments to a law in 2000 which clarified the prior ambiguity in the area) that CDSs are specifically excluded from the definition of a “security”, it’s not clear what relevance that has. Presumably the SEC has some insight as to what US regulators think a “Security” is?
Smith: Do you think he was comletely unaware of the regulatory framework for the SINGLE MOST IMPORTANT ISSUE ON HIS PLATE AT THAT MOMENT IN TIME?
Yes. Politicians are not securities lawyers. Also, politicians often know the rules, but they try to spin things so that they don’t get blamed.
As a point of fact, a US insurance company (or anyone else) cannot and since 1934 has not been able to sell credit derivative swaps in the United States without a license from the SEC, which will not give such approval. No rule against a US company selling them in Germany, and in fact the SEC doesn’t have the legal authority to prevent a US company from selling oversees derivatives. Now the state of New York does have the legal authority to prevent a NY company from selling CDS in Germany, but they never thought to use it before 2007. Why should the state of NY care what happens in Germany, I mean, it’s not as if we live in a networked world…
Similarly what AIG did would have been impossible had it been a English company selling CDS in England. Or a German company selling CDS in Germany.
The problem was that each country had a block the sale at a specific point, and someone that was very clever would have been able to circumvent the blocks.