Economics Shares The Blame
We are not short of causes for our current economic crisis. The basic machinery of capitalism, including the process of making loans, did not work as it was supposed to. Capital flows around the world proved much more destabilizing than even before (and we've seen some damaging capital flows over the past 200 years.) And there are plenty of distinguished individuals with something to answer for, including anyone who thought they understood risk and how to manage it.
But perhaps the real problem lies even deeper, for example, either with a natural human tendency towards bubbles or with how we think about the world. All of our thinking about the economy - a vast abstract concept - has to be in some form of model, with or without mathematics. And we should listen when a leading expert on a large set of influential models says (1) they are broken, and (2) this helped cause the crisis and - unless fixed - will lead to further instability down the road.
This is what my colleague, Daron Acemoglu, is saying in a new essay, "The Crisis of 2008: Structural Lessons for and from Economics." (If you like to check intellectual credentials, start here and if you don't understand what I mean about models, look at his new book.) To me there are three major points in his essay.
1. The seeds of the crisis were sown in the Great Moderation (the low inflation, relatively stable last 20 years or so). Everyone who patted themselves or others on the back during that time was really missing the point (p.3). The same interconnections that reduced the effects of small shocks created vulnerability to massive system-wide domino effects. No one saw this clearly.
2. The predominant view was that the US and other relatively rich countries had pretty good institutions (i.e., rules, laws and practices underpinning economic transactions) and that these institutions would prevent powerful people from the kind of abuse that endanger social systems in many parts of the world (pp.4-5). That view was incorrect. (Speaking personally, I had no illusions about the power of the strongest on Wall Street - particularly after my experience on the SEC's Advisory Committee on Market Information in 2000-2001. But I didn't have the right mental model of how this power aggregated up, i.e., the way in which these people, and the firms they controlled, had created or recreated a deeply unstable system.)
3. The way we think about reputation, including how it is acquired and maintained, is way off base (pp.6-7). This is fundamental for both formal economics and how you go shopping. You walk into a grocery store with a mental model that is based on the premise that the individuals all through the production chain operate in a control structure designed to build brands and make you think their products are healthy and tasty. Such reputations are costly to build and not readily squandered. But, Daron points out, this is too simple. In particular, we should no longer make the mistake of saying "the company" wants this or that. There are no companies in any kind of behavioral sense. There are people, struggling to get ahead, and it is their interactions that can lead - particularly in finance - to products that are really terrible for you and your neighbors (and even quite bad for themselves).
Daron also urges that we not lose track of longer term economic growth issues in the current policy debate. If the bailout process - including the evergreening of credit by the Federal Reserve - slows down or even freezes the reallocation of resources out of the financial sector, we have a problem. We need to move, at least somewhat, out of a bloated financial sector and back into the kind of nonfinancial technology-developing sectors that have primarily driven growth in the US since the 1840s.
This is not an argument against a comprehensive stimulus package. But it recognizes the legitimacy of any backlash both against the models that brought us here and many of the sweet deals for leading financial figures (received so far and no doubt currently pencilled in). Beginning with designing, arguing about, and implementing the stimulus, we need to think more clearly about the economics and politics of how we rebuild the financial system. If we recreate something fundamentally unfair and unstable, that will also undermine growth.
It's not fair! Robert Fulghum
In all these discussions of how to keep the bubble inflated in order that the least possible damage be done to the "economy," there is little discussion of the moral consequences -- and I'm not talking about "moral hazard" -- I'm talking morality.
Do we want to live in a society which works hard, saves its money and is responsible for its retirement or do we want to live in a careless, irresponsible society where traditional verities are despised?
Folks, there are consequences to profligate behavior. I say we take the recession and the devil take the hindmost.
January 8, 2009 11:44 AM | Reply | Permalink
Just to be clear --
I have no qualms with extending unemployment benefits and strengthening the welfare system. But spending trillions to keep the housing bubble inflated and Citibank's employees out of the UI offices or as Obama plans to do, $250,000 for each job "created," is immoral.
January 8, 2009 12:07 PM | Reply | Permalink
"The basic machinery of capitalism, including the process of making loans, did not work as it was supposed to."
Says who? It worked to perfection for those very few rich and powerful who benefitted by the consolidation of wealth into their pockets.
Through the fractional reserve system for loaning money, banks were getting over a 50% annual return on their money and on any money that was deposited with them.
Giving the bankers billions in bailout money in addition to all their profits over the last several years was just criminal.
January 8, 2009 3:59 PM | Reply | Permalink
Ellen, the point is not what does or does not do the most damage to "the economy". The point is, we need to do what will cause the least amount of damage to, and offer the greatest potential for repair of, our society.
We live in a society, not an economy. You either fail to understand this or are deliberately ignoring that fact.
January 8, 2009 1:02 PM | Reply | Permalink
The economy is a second order derivative of the society in which it is located.
It is the moral strength of a society which makes an economy function efficiently -- and fairly. "Save" the economy at the cost of undermining society's morality -- and policies which are seen to be antithetical to established moral tenets will do just that -- and in the end the economy will suffer.
January 8, 2009 3:27 PM | Reply | Permalink
OK, I get it - you are deliberately ignoring it. And trying to obscure that with your BS.
January 8, 2009 8:18 PM | Reply | Permalink
I wonder what you think of the politics of it.
It seems to me that labor lost political power beginning with the Reagan Revolution, and that unbalanced our political system towards financiers, CEO's, and the like. We indulged one faction at the expense of another.
Thus we have a consumer economy, which has been the growth driver of globalization, built on the backs of workers with declining wages, job security, and benefits. The gap was filled with a credit bubble. Of course this was unstable.
I think economists in my experience often see society in terms of numbers, not people. If the numbers can be spun to make it look good (e.g. a credit bubble) they don't see the forest for the trees.
Your thoughts?
January 8, 2009 1:32 PM | Reply | Permalink
My view is that we need to reconstruct economics before we can use it to reconstruct the financial system. The era just ending has been one in which the individual was lauded, debt was encouraged, wealth was concentrated, and, crucially, regulation was cast aside as unnecessary. We were told that the 'market' would solve all our troubles 'more efficiently' than government or other institutions. This is the free market dogma of the standard textbooks and fits nicely with the 'devil take the hindmost' individual-is-all philosophy of the modern GOP. It also suits anyone with enough clout to ensure that their particular patch of the economy is left well alone by government regulators.
The current collapse is therefore just as much an indictment of the underlying academic theory as it is of the political gloss put on that theory by the right wingers.
It doesn't take too long to see that standard economic theory is not about real economies. It describes ant populations well, but has a hard time dealing with the irrationality of regular folks like us. Hence the prevalence of bubbles. It is the height of irony that the common denominator of the prescriptions being offered by economists is their Keynesian basis: standard theory was supposed to have repudiated and supplanted Keynes. I also find it a tad unethical for a load of tenured economics professors to preach to us about the efficacy of getting rid of restrictions on labor markets in the name of efficiency. I will listen to them once they've abandoned tenure!
I agree with 'Grouch' above: the economy is embedded in society. The two are interdependent. Allowing an economic free fall the way Ellen seems to propose is the same thing as allowing society to free fall. We are in this thing together whether we want to face that fact or not. So spending a ton of money [and I think it will cost a lot more than Obama is proposing] to prevent further chaos is cheap by comparison with the alternative. The notion that, somehow, we are individuals and that by looking after ourselves we will survive without damage is simply to ignore the massive complexity of the modern economy. And I think it is specious reasoning to express the stimulus spending in terms of dollars per job saved or created. We could equally talk in terms of schools built, bridges repaired, and roads paved. They are meaningless statistics. It is the overall objective we should focus on: stopping the slide into another Depression.
The whole exercise is one of recognizing that there is a national or communal crisis that has to be addressed. Keynes spoke of the 'paradox of thrift' where the rational response to a downturn by an individual is to cut spending and save. The problem is that the sum of all those rational individual decisions is an irrational communal decision: because everyone is sensible we condemn ourselves as a society to a downward spiral.
Only massive spending stops that spiral. And if it hurts to say that it costs $250,000 per job, then think of it as $250,000 per food riot avoided.
January 8, 2009 2:20 PM | Reply | Permalink
Except that Keynes was wrong!
The way out of a recession/depression is not to increase consumption -- that's what got us into the downturn together with cheap credit which generated malinvestments -- but to increase savings that can be employed in economically rational and efficient investments.
In the event a society which does not save is childish and without moral character and frankly, I'd just as leave not have to be associated with such a society.
January 8, 2009 3:40 PM | Reply | Permalink
re Ellen: Without consumption, producers hurt and fail. So consumption is necessary and good in a recession or not. But over consumption, and arguably wasteful consumption, are generally neither.
That said, I see savings as being the building future consumption power, and spending as being current consumption. If Ellen's point is that churning doesn't help in the long run, I agree. We build savings today so as to be able to spend tomorrow. But where can we save effectively today, in our circumstances?
If society is zeroth order, and economy is second order, what are the other second orders and what is the first order derivative(s)?
January 8, 2009 9:39 PM | Reply | Permalink
January 9, 2009 6:38 AM | Reply | Permalink
When an individual, company, or government finds itself in economic trouble, the answer to that problem is to either spend less, increase income, or do both.
The US government is doing just the opposite, increasing spending while decreasing income.
This is a recipe for disaster since it only expands the credit bubble instead of deflating it.
There will soon come a time when the bailout and/or spending process has to be repeated at a much larger level.
The real problem is the belief that debt creates wealth. It doesn't.
Also, a government printing money to pay off their debts is also counterproductive.
Think of there being $3 Trillion dollars in circulation to purchase all the goods and services produced in the USA. Then the governmnet prints an additional $3 Trillion dollars without increasing the amount of goods and services being produced. What happens is that those people controlling the goods and services just double their prices. That is called inflation and is the path taken by Germany in the late 1930's when a wheelbarrow full of currency was needed to buy a loaf of bread. It is also the path taken more recently by Zimbabwe. Check their currency against the dollar.
The results of inflation hurt the poor, the middle class, and those on fixed incomes much more than it hurts the rich.
Consider, there is a minimum amount needed to provide the basics for survival. Say, this figure is $20,000 per year per person. A person receiving $25,000 per year is $5,000 per year above the basic survival level while a person receiving $150,000 is $130,000 above basic survival status. Now, inflate the currency by 50%. It now takes $30,000 per year for the basic survival level. The person receiving $25,000 per year is now below the basic survival level while the person receiving the $150,000 is still $120,000 above basic survival level.
Both the bailouts and any "economic stimulus package" can only serve to make the basic economic problems greater.
The only real solution is to cut government spending, increase taxes, and/or both in order to pay for the excess spending of both the US government and private individuals over the last however many years, reduce debt, and allow those failing institutions to fail. In other words, suffer the consequences of the spending spree.
Don't expect this to happen anytime soon.
January 8, 2009 3:49 PM | Reply | Permalink
Academic economists will not be making the decisions that will lead us out of this mess. All decisions will be made in the political process. For the past 30 years this was also true, but most people were will to defer to the advice of the financiers and their academic advisors. Their credibility is now shot and more people will think for themselves. As evidenced by the comments here, probably a relatively homogeneous subgroup of the larger public, different people will be thinking wildly different things.
Today, right or wrong, the political currents are leading to a Keynsian solution. We are going to start spending big time to try to stimulate aggregate demand. I have no idea as to whether or not this will work. One of the risks is hyper inflation, and based on historical precedent (Weimar Germany in the 1920s and post WWII China) this is a danger that could be much worse than even a bad depression.
But of course I am biased here been a saver and not indebted.
January 8, 2009 5:00 PM | Reply | Permalink
I'm concerned about inflation too. But the USA today is not much like either of your historical comparisons, is it?
I don't see how spending stimulates demand. It would seem to stimulate production, and compete with extant consumption.
I'm concerned that the trillions the Fed has printed in service to corporate paper etc. will stick around and show up as huge increases in CPI as all that money filters into the ordinary economy in which individuals participate daily.
Is it too late to argue effectively against the Keynsian solution method (as you called it)?
January 8, 2009 9:46 PM | Reply | Permalink
I wasn't comparing the economies of Germany and China to ours, I was simply pointing out the political consequences of hyper inflation in those two cases.
January 8, 2009 10:14 PM | Reply | Permalink
But you must think they are illustrative of our current situation. I'm saying that if our fundamentals are very different, they don't illustrate plausible forward paths we might find ourselves on, economically or politically.
If your point is that hyperinflation can sometimes lead to major political instability ... then those who favor political stability following economic and monetary crises had better get aworkin' ...
January 9, 2009 2:11 AM | Reply | Permalink
eds:
What "fundamentals" are you referring to?
A government going over its head into debt?
A government printing money (or T-Bills) to pay for that debt?
Or, a government trying to spend it's way out of debt?
These "fundamentals" apply for China, Germany, Zimbabwe, and now, the USA.
January 9, 2009 7:40 AM | Reply | Permalink
No, actually they don't.
January 9, 2009 4:50 PM | Reply | Permalink
I can't help but post this:
"a natural human tendency towards bubbles"
For some reason, I am reminded of the bloody and terrible wal-mart stampede this holiday shopping season. And we want to widen the automatic doors. Everyone just wants to make a cheap buck.
January 8, 2009 11:20 PM | Reply | Permalink
"These "fundamentals" apply for China, Germany, Zimbabwe, and now, the USA."
eds says, "No, actually they don't."
How do they not apply, as you see it? Johann's assessment seems to make sense to me.
January 9, 2009 4:59 PM | Reply | Permalink