Putting up another post all too quickly between conference sessions:
Forecasts vs mechanisms in economics, by Chris Dillow: This discussion between Edmund Conway and Andrew Lilico on the Today programme on the alleged crisis in economics seems to me to rest upon a misunderstanding of what economics is.
Conway says the crisis has been "an earthquake for economic thought" and Lilico says we need "new theories." This, though, seems to regard economics as a settled but inadequate body of knowledge and theory. It's not. It is instead a vast number of diverse insights. What's more, all of the insights that help explain the current economic crisis were, in truth, well known to economists before 2007, for example:
- Risk cannot be simply described by a bell curve. But we learnt about tail risk on October 19 1987. And we learnt from the collapse of LTCM in 1998 that correlation risk, liquidity risk and counterparty risk are all significant.
- Assets can be mispriced. But we've known about bubbles for centuries - since at least 1637. Their existence does not disprove the efficient market hypothesis; as I've said, the EMH is not the rational investor hypothesis. Nor, contrary to Conway's implicit claim, is the EMH inconsistent with the possibility that behaviour can be swayed by emotions; the EMH allows for the possibility of time-varying risk premia*
- Long periods of economic stability can lead to greater risk-taking. We've known this since (at least) Hyman Minsky.
- Banks can suffer catastrophic losses - which are correlated across banks. We learnt this - not for the first time - in the Latin American debt crisis of the early 80s and in the crises in Japan and the Nordic countries in the early 90s. Banking crises are a regular feature of even developed economies.
- Institutions, such as banks, can be undermined by badly designed incentives. But there's a huge literature on the principal-agent problem.
- The current crisis, then, has not thrown up much that economists didn't know. Instead, our problem is a different one. It's that what we have are lots of mechanisms, capable of explaining why things happen and the links between them. What we don't have are laws which generate predictions. In his book, Nuts and Bolts for the Social Sciences, Jon Elster stressed this distinction. The social sciences, he said:
Can isolate tendencies, propensities and mechanisms and show that they have implications for behaviour that are often surprising and counter-intuitive. What they are more able to do is to state necessary and sufficient conditions under which the various mechanisms are switched on.
This is precisely the problem economists had in 2007. We knew that there were mechanisms capable of generating disaster. What we didn't know is whether these were switched on. The upshot is that, although we didn't predict the crisis, we can more or less explain it after the fact. As Elster wrote:
Sometimes we can explain without being able to predict, and sometimes predict without being able to explain. True, in many cases one and the same theory will enable us to do both, but I believe that in the social sciences this is the exception rather than rule.
The interesting question is: will it remain the exception? My hunch is that it will; economists will never be able to produce laws which yield systemically successful forecasts.
What's more, I am utterly untroubled by this. The desire for such laws is as barmy as the medieval search for the philosopher's stone. If you need to foresee the future, you are doing something badly wrong. * The basic insight of efficient market theory is that you cannot out-perform the market except by taking extra risk. I am sick and tired of hearing people who still have to work for a living trying to deny this.
I think the statements on prediction are overly broad. If you raise the price of a good, in all but a few cases such as when price is interpreted as a signal of quality, we can predict what will happen, quantity demanded will fall. By exactly how much will quantity demanded fall? In some microeconomic applications, the bounds can be fairly tight. For example, I suspect Hal Varian at Google - who has access to vast amounts of data and the ability to conduct all else equal type experiments - has a fairly tight estimate of important parameters that indicate how, say, changing the price of an ad will impact Google's revenue stream. He has also been doing some interesting work on prediction, e.g. see Predicting Initial Claims for Unemployment Benefits. But in other cases, particularly in macroeconomics and the prediction of turning points, success has been much more modest (or absent altogether). However, I am not as pessimistic as Chris that we will never be able to do predict the course of the economy, but it will require that we begin to better understand how pressures build within the macroeconomic system, how to measure and monitor these pressures (e.g. measures such global and sectoral imbalances or price rent ratios, but those are hardly sufficient in and of themselves), and ultimately how to relieve the pressures when they begin to build to threatening levels.
When it comes to health care, "government involvement is the only reason our system works at all":
Health Care Realities, by Paul Krugman, Commentary, NY Times: At a recent town hall meeting, a man stood up and told Representative Bob Inglis to "keep your government hands off my Medicare." The congressman, a Republican from South Carolina, tried to explain that Medicare is already a government program — but the voter, Mr. Inglis said, "wasn't having any of it."
It's a funny story — but it illustrates the extent to which health reform must climb a wall of misinformation. It's not just that many Americans don't understand what President Obama is proposing; many people don't understand the way American health care works right now. They don't understand, in particular, that getting the government involved in health care wouldn't be a radical step: the government is already deeply involved, even in private insurance.
And that government involvement is the only reason our system works at all.
The key thing you need to know about health care is that it depends crucially on insurance. You don't know when or whether you'll need treatment — but if you do, treatment can be extremely expensive, well beyond what most people can pay... Triple coronary bypasses, not routine doctor's visits, are where the real money is, so insurance is essential.
Yet private markets for health insurance, left to their own devices, work very badly: insurers deny as many claims as possible, and they also try to avoid covering people who are likely to need care. Horror stories are legion...
And in their efforts to avoid ... paying medical bills, insurers spend much of the money taken in through premiums ... on "underwriting" — screening out people likely to make insurance claims. In the individual insurance market,... so much money goes into underwriting and other expenses that only around 70 cents of each premium dollar actually goes to care.
Still, most Americans do have health insurance, and are reasonably satisfied... How is that possible, when insurance markets work so badly? The answer is government intervention.
Most obviously, the government directly provides insurance via Medicare and other programs. ... Medicare — which is ... one of those "single payer" systems conservatives love to demonize — covers everyone 65 and older. And surveys show that Medicare recipients are much more satisfied with their coverage than Americans with private insurance.
Still, most Americans under 65 do have some form of private insurance. The vast majority, however, don't buy it directly: they get it through their employers. There's a big tax advantage to doing it that way... But to get that tax advantage employers have to follow a number of rules; roughly speaking, they can't discriminate based on pre-existing medical conditions or restrict benefits to highly paid employees.
And it's thanks to these rules that employment-based insurance more or less works, at least in the sense that horror stories are a lot less common than they are in the individual insurance market.
So here's the bottom line: if you currently have decent health insurance, thank the government. ...
Which brings us to the current debate over reform.
Right-wing opponents of reform would have you believe that President Obama is a wild-eyed socialist, attacking the free market. But unregulated markets don't work for health care — never have, never will. To the extent we have a working health care system at all right now it's only because the government covers the elderly, while a combination of regulation and tax subsidies makes it possible for many, but not all, nonelderly Americans to get decent private coverage.
Now Mr. Obama basically proposes using additional regulation and subsidies to make decent insurance available to all of us. That's not radical; it's as American as, well, Medicare.
Brad DeLong asks Do I Dare Click Through on This article by Jonah Goldberg? He then answers "No. I do not. I will remain forever ignorant..."
I dared to click through. Next time, I won't bother, and let me save you the trouble. The argument is that we don't spend enough to fight the threat of asteroids, so we must be spending too much fighting global warming, but one doesn't follow from the other. I see now why I can't remember the last time I read an article by Goldberg.
Maybe this sudden bout of timidity from Brad DeLong is my fault (though there is a sign he is recovering). Last night, I was the one who didn't dare click through on an article, so I sent the link to Brad saying "I just couldn't read this. Maybe tomorrow." Looks like that may have sent him over the edge:
Someone Is Saying Something Wrong
on the Internetin the Pages of the Wall Street Journal, by Brad DeLong: Someone Is Saying Something Wrong on the Internetin the Pages of the Wall Street Journal!
My friend Mark Thoma is trying to diminish my quality of life by emailing me links to Donald Luskin writing in the Wall Street Journal:
Luskin: President Barack Obama proposed last month that the Fed act as an overall "systemic risk" regulator, with consolidated supervisory responsibility over "large, interconnected firms whose failure could threaten the stability of the system." Now William C. Dudley, the ex-Goldman Sachs economist just appointed president of the New York Federal Reserve, has upped the ante.... Mr. Dudley is effectively asking for the power to control asset prices...
The Federal Reserve is not "asking for the power to control asset prices." It already has the power to control--or, rather, profoundly influence--asset prices already. When the Federal Reserve carries out an expansionary open-market operation, the whole point of the exercise is that it boosts bond and stock prices. The Federal Reserve buys bonds for cash. There are then fewer bonds out there for the private sector to hold. By supply and demand, the prices of those bonds goes up, and their yields--the interest rates quoted in the financial press--go down. Also by supply and demand, when bonds are yielding less investors are willing to pay more for substitute assets like equities and real estate, and their prices go up as well.
When the Federal Reserve carries out a contractionary open market operation, the same process works in reverse: the whole point of the exercise is that it lowers bond and stock prices. The Federal Reserve sells bonds for cash. There are then more bonds out there for the private sector to hold. By supply and demand, the prices of those bonds goes down, and their yields--the interest rates quoted in the financial press--go up. Also by supply and demand, when bonds are yielding more investors are willing to pay less for substitute assets like equities and real estate, and their prices go down as well.
For Luskin to claim that Dudley is asking for something new--that there is an extraordinary increase in the big, bad government's power to regulate financial markets contained in Dudley's "effectively asking for the power to control asset prices" is to demonstrate a degree of cluelessness that takes my breath away. The Federal Reserve already has the power to control asset prices. It has had this power since its founding in 1913. That's the point. That's what a central bank does. That's what it's for: it's an island of central planning power seated in the middle of the market economy.
If you don't like it, call for its abolition. But don't pretend that it isn't there--don't pretend that "Mr. Dudley... asking for the power to control asset prices" is some wild change in our current system.
Jeebus save us...
So what did Federal Reserve Bank of New York President William Dudley say at the 8th Annual BIS Conference in Basel last June 26?
We had not understood that interconnection had breached the firewalls of the banking system--that it was no longer enough to guarantee the stability of the financial system that the FDIC guaranteed deposits and the Federal Reserve supervised commercial banks, as we saw when the disruption of the securitization marktes of the shadow banking system quickly transmitted itself to the entire financial sector and caused the biggest globl economic decline since the Great Depression. Thus "the U.S. Treasury is right in proposing a systemic risk regulator as part of their regulatory reform plan... we shouldn't kid ourselves about how difficult this will be to execute.... It will take the right people, with the right skill sets, operating in a system with the right culture and legal framework. I don't believe creating this oversight process will be an easy task"...
We need to try to "engineer out of the financial system" destabilizing positive-feedback mechanisms like: (a) collateral tied to credit ratings; (b); collateral and haircuts; (c) compensation "tied to short-term revenue generation, rather than long-term profitability over the cycle"; (d) incentives for banks to fail to "raise sufficient capital to be able to withstand bad states of nature... many banks did not hold sufficient capital and market participants knew this"...
Specifically, we need to add debt that automatically converts to equity on the downside
And, specifically, we need CDOs and other securitized obligations that are easier to value, and we need more public reporting of exposures.
It's only after this that Dudley gets to monetary policy and asset bubbles, and his belief that we need "a critical reevaluation of the [Greenspanist] view that central banks cannot identify or prevent asset bubbles, they can only clean up after asset bubbles burst." There is an opportunity for the government to "lean against the wind" in real time, Dudley believes, and cites as an example that "the compressed nature of risk spreads and the increased leverage in the financial system was very well known going into 2007."
The problem with "leaning against the wind" to some degree to try to curb the growth of asset bubbles, Dudley says, is that the standard tool that the Federal Reserve uses to affect asset prices are open-market operations directed at the short end of the yield curve, and "the instrument of short-term interest rates... is not well-suited to deal with asset bubbles." The problem is that using short-term interest rates to manipulate asset prices raises or lowers all asset prices together, which means that one risks curbing the bubble by attacking the economy and causing the recession one wants to avoid. In a bubble the Federal Reserve does not want to lower all asset prices but, rather, just the prices of those risky assets that are affected by the bubble.
One way to think about it is that standard Fed tools allow it to affect the market rate of time preference and thus the level of asset prices, but that the configuration of asset prices is actually a two-dimensional animal in which both the rate of time preference and the premium on risk are important. The Fed then needs two different policy instruments to do its job. Open-market operations that affect the rate of time preference are one. And Dudley thinks that banking collateral regulatory policy--"we might give a systemic risk regulator the authority to establish overall leverage limits or collateral and collateral haircut requirements... limit leverage and more directly influence risk premia..."
But nobody should believe the Wall Street Journal when it tells us that Dudley wants to move us into a world in which for the first time the Federal Reserve "is effectively asking for the power to control asset prices." That's not what is going on at all.
Why oh why can't we have a better press corps?
Andy Harless explains why he believes that much of the recent increase in the savings rate will be permanent, while Brad DeLong thinks "only a small part" will be permanent. My own view is somewhere between Andy's "much" and Brad's "small part":
Savings Rate Could Stay High, by Andy Harless: Mark Thoma shows us a historical chart of the personal savings rate since 1960 and asks how much of the recent increase (from an average of about 0.5% from 2005 through 2007 to a peak of almost 7% in May of this year) is permanent? One must, of course, take the May figure with a grain of salt: the savings rate rose in May largely because tax withholding was reduced; unless that attempt at a stimulus is completely ineffective, we should expect the savings rate to decline as people start taking advantage of the new disposable income. But even before May the savings rate this year was running consistently above 4%, which is a dramatic change from a few years ago. Let's use the April figure – 5.6% – as a guesstimate of what the "true" savings rate is right now and ask how much of that will be permanent. Not much, thinks Brad DeLong:
I would guess that only a small part of the rise in the savings rate is permanent. Financial distress was and is much greater than in past post-WWII recessions, and financial distress is associated with transitory rises in the savings rate.
I'm inclined to disagree. Undoubtedly the savings rate will fall somewhat as the degree of financial distress declines, but I think there's a good case to be made that much of the increase is permanent.
For one thing, from the point of view of households, "financial distress" may be extremely slow to lift. If the Japanese experience is any guide, it is a very slow process to get a severely distressed banking system to start lending normally again, and it's not clear that things are going to be any easier for the US. Meanwhile, most forecasts expect the unemployment rate to remain quite high for several years. It could take 3 years, or 5 years, or 10 years, or 20 years before the financial distress lifts.
Granted, even 20 years is not forever, and 3 years is certainly not forever, but it's long enough to stop thinking about household behavior as being continuous over time. We can reasonably surmise that, even without so much financial distress, the savings rate would have trended upward over time. Presumably households would gradually have come to recognize that they weren't saving enough. (Can zero be anywhere near enough?) And as baby boomers' children settle into their own careers, they would cease to be a drag on their parents' savings, and at the same time those parents would have to start worrying seriously about retirement. The financial distress messed up this scenario (or maybe just speeded it up), but the underlying trend should still be going on "beneath the surface." By the time the distress lifts, there will be other reasons for the savings rate to be higher than it was in 2006.
That argument is rather speculative, I admit, but there are more solid reasons to expect the savings rate to remain high.
While the current, comparatively high savings rate may reflect the effects of financial distress, the low savings rates of the 2005-2007 period did not merely represent the absence of financial distress. What is the opposite of financial distress? Financial ease? The degree of financial ease during that period (which was the culmination of a process that had been building on and off for a couple of decades) was well beyond normal, and well beyond what we can expect in the coming years, even if recent sources of distress are resolved fairly quickly. Consumption was supported (and aggregate saving accordingly reduced) by a fountain of credit that will not re-emerge with such force unless people in Washington and on Wall Street make some big mistakes.
The ready availability of credit to consumers was in large part the result of lax regulation, careless investing, and the assumption that home prices would never decline significantly on a nationwide basis. With respect to regulation, the pendulum is clearly swinging in the other direction now. Careless investors have learned their lesson for a generation. And housing prices have disproven the earlier assumption.
After the collapse of housing prices, not only will lenders be more cautious: borrowers also won't have as much collateral. It will be quite a while before typical homeowners have as much equity as they did in 2006.
Moreover, the meltdown may have shaken confidence in the concept of securitization to the point where it will take a decade or more to restore even healthy securitization markets (if they can be restored at all), let alone the severely intoxicated ones that we were seeing in 2006. It won't be easy for households to borrow money for consumption in the coming years. The ones that had negative savings rates will be much less common, while the ones that had positive savings rates will still be there. I expect we'll be seeing savings rates noticeably higher than zero for years to come.
Where are the technocratic institutions?:
I do have one big question. The US government especially, but other governments as well, have gotten themselves deeply involved in industrial and financial policy during this crisis. They have done this without constructing technocratic institutions like the 1930's Reconstruction Finance Corporation and the 1990's RTC, which played major roles in allowing earlier episodes of extraordinary government intervention into the industrial and financial guts of the economy to turn out relatively well, without an overwhelming degree of corruption and rent seeking. ...
So I wonder: why didn't the US Congress follow the RFC/RTC model when authorising George W. Bush's and Barack Obama's industrial and financial policies?
...I think it's an interesting question..., so I'll take this chance to offer my response. With regard to TARP, I think Congress didn't set up an RTC-like institution because the feeling was that there simply wasn't enough time. Neither the RTC nor the RFC were set up during market panics. By the time the RTC was set up in 1989, the S&L crisis had been raging for several years, and the 1987 stock market crash had come and gone. Similarly, the RFC was created in January 1932—over 2 years after the stock market crash of '29.
Time was of the essence back in September, and in order to respond with the necessary speed and force, more discretion had to be given to the executive branch. The RTC, for example, was run by a board of directors and a separate oversight board. In a crisis, policy-by-committee doesn't work. The market had to be confident that help was coming soon, and wouldn't be held up by internal government bickering (think Sheila Bair).
Why wasn't an RTC-like institution created once the financial markets more or less stabilized, and time was no longer of the essence? That's easy: because Congress already gave the executive branch the money. In the administration's view (which I largely share), there's no real benefit from creating a separate "technocratic" institution to administer TARP. Treasury is a highly "technocratic" institution itself, as DeLong no doubt knows, having worked in the Clinton Treasury. I have great confidence in Tim Geithner's competence—in fact, I don't think there's anyone I'd rather have in charge of TARP.