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September 17, 2009

Economist's View - 4 new articles

"Did Economists Ever Get it Right?"

Antonio Fatás on the state of macroeconomics:

Did Economists Ever Get it Right?, by Antonio Fatás, Commentary, MorningStar (originally): Paul Krugman has written a nice essay on the NY Times about How did economists get it wrong?. Other economists have written on the same topic: Eichengreen, Lane, Thoma, DeLong.
My reading of these articles is that there is a good deal of consensus around the following points:
1. Many (economists and non-economists) had expressed concerns prior to the crisis about economic imbalances such as excessive asset price appreciation or current account imbalances. They pointed out to the need of an adjustment, which could come in the form of a recession. As it has always been the case with recessions, forecasting the exact timing is not easy...
2. There were several scenarios that were discussed prior to the crisis that could lead to a significant economic downturn. They involved a crash of the real estate market (which took place) and in some cases a reversal of capital flows as foreigners would stop lending to the US (or they would do so at much higher rates). This second scenario never materialized - the crash in real estate prices was enough.
3. Even among those who were concerned with the possibility of a crisis, very few understood the potential magnitude of the crisis, mainly because they could not foresee the collapse of the financial system that we witnessed a year ago. Here is a quote from Frederic Mishkin...:
The big gains in housing prices we have seen here and in many other countries have raised concerns about what might happen to economic activity if those price gains are reversed. ... Fortunately, the overall financial system appears to be in good health and the US banking system is well positioned to withstand stressful market conditions.
Clearly, our knowledge of what was happening inside the financial system and the associated risk was very limited. This is a failure of regulation and we learned the lesson the hard way.
4. No doubt that some of the research that was done by economists (those in academia) did not provide any clue about what was about to happen. As Phil Lane argues in his article, this is partly a result of specialization, not all researchers are into the business of forecasting economic downturns. But there is also no doubt that some of the research in macroeconomics has been anchored in models that do no recognize enough failures in markets or deviations from rational behavior to produce or understand some of the phenomena that led to the current crisis. Part of this is because of ideological reasons (some want to believe that markets always work), part of this is because the "beauty" of dealing with simple models (the argument made by Krugman in his article).
One thing that I find missing in all those articles is whether there was any difference between the current crisis and the previous ones. I am not sure there is much difference. Prior to the (mild) recession of 2001 we also witnessed very similar dynamics: many expressed concerns about the valuation of stocks (more so for tech stocks). But they called the crisis way before it happened. Once it happened, we all asked the question "How did we get it so wrong?". The difference with the current crisis is that this one is bigger, so more questions are being asked. Also, economic policy has played a much stronger role during the crisis, which has probably led to a stronger debate around economics.
It is also interesting to see that during the boom year, there was as much skepticism of economists' forecasts as today so even if some economists were getting it wrong, it is unclear how much they were driving market expectations or investment and spending decisions.
We will have to wait for the next crisis and see if things have changed or we just need to conclude that economists "will never get it right".

On point 4, I'll just add one thing. Besides the anchoring from ideology and beauty, part of the problem too, as I've argued before, is that we weren't asking the right questions. [I should also add that the reason we didn't ask the right questions may be tied to ideology, and perhaps the elegance of the supporting theoretical structure as well, that led to the belief in self-correction and self-protection from large shocks that made massive meltdown very unlikely if not impossible.] I have criticized regulators for not having plans ready to deal with too big to fail institutions. One thing everyone seems to agree on is that the ad hoc response from regulators made things worse, and we need to be better prepared with plans to dismantle these firms without destabilizing markets next time around (and do our best to prevent problems from developing to begin with, including regulating connectedness). The fact that we were caught without such plans was a big handicap in dealing with the unfolding crisis.

But the same can be said about macroeconomics. We didn't plan for a big crisis either. That is, we didn't take the threat of a large breakdown seriously enough to take the time to develop a theoretical framework that could anticipate these problems and guide us in how to deal with them if they occurred. There were stabs in this direction, but it was by no means a major effort or thought to be one of the more important research questions. We spent a lot of time developing stabilization policy, but it wasn't within a framework that was particularly helpful for the kinds of problems we are facing today. We had no plans on the shelf that we could rely upon when the crisis hit, and what we have seen from macroeconomists is the same kind of ad hoc scramble for an effective response that many of us have criticized regulators for. But if macroeconomists had taken the possibility of a massive meltdown seriously before it happened and developed the theoretical apparatus we are now calling for now that we have seen that such events are, in fact, possible, then perhaps regulators would have been more inclined to think through this possibility and get ready for it. I don't think the blame is all theirs.

How Should Policymakers Respond to Inflation, Output, and (Lack of) Employment?

There is news on weekly jobless claims. Despite all the attempts to paint this as good news, the fall of 12,000 from the previous week is being highlighted in many places, 545,000 new claims is still very high and indicates that the recession is not yet over for workers:

Jobless Claims Decline, WSJ: Initial claims for jobless benefits fell 12,000 to 545,000 in the week ended Sept. 12...
The four-week average of new claims, which aims to smooth volatility in the data, fell by 8,750 to 563,000 from the previous week's revised figure of 571,750.
With claims still at a fairly high level, the data seems to reinforce the idea expressed earlier this week by U.S. Federal Reserve Chairman Ben Bernanke that the recession is most likely over from a technical standpoint but it will take time for the labor and credit markets to recover...
The ... number of continuing claims -- those drawn by workers for more than one week in the week ended Sept. 5 -- rose by 129,000 to 6,230,000 from the preceding week's revised level of 6,101,000.

Amid all the optimism that seems to be pervading the coverage of the economy, a mood that is being intentionally stoked by policymakers eager to rebuild confidence, we'll have to keep reminding everyone that workers still need help (I'm seeing more and more stories, for example, about unemployment benefits running out for some workers even as long-term unemployment continues to rise). As this picture from the SF Fed shows, the employment series does not yet display the "fishhook" shape shown in other series that are the source of the declarations that the worst is behind us. And as the experience of the last recession in the graph below shows, the trough in employment can be far behind the trough in output:

One more note on this. I was pleased to see McClatchy News at least asking the question in "Will Obama, Fed tolerate another jobless recovery?," so it's not completely off the radar and perhaps this will help to get the message to policymakers in congress. As for the Fed, as the futures market for the federal funds rate shows, markets believe rate hikes aren't far away indicating a belief among market participants that as output begins recovering, inflation worries will trump concerns about employment:

"The Triumph of Central Banking?"

Paul Volcker discusses the usefulness of macroeconomic policy:

Paul A. Volcker In Conversation with Gary H. Stern, Minneapolis Fed (pdf): ...Economic knowledge and central banking
Stern: You've obviously been involved for a long time directly with the Federal Reserve, at senior levels, from the mid '70s and even earlier than that in the Treasury as well. In your view, has macro policy or monetary policy changed significantly over those many years? Or are we still pretty much at the state of knowledge, and is the state of our responses pretty much where it was?
Volcker: [Laughter] It's interesting you ask that question because I recently commented to some of my economist friends that I'm not aware of any large contribution that economic science has made to central banking in the last 50 years or so.
Our ability to forecast is still very limited. The old issues of the relative role of fiscal and monetary policies are still debated. Markets are certainly more complex, and some of the old approaches toward monetary control seem less relevant. Recent events have certainly illustrated limitations in our understanding of the economy.
The advent of floating exchange rates, which partly reflects a shift in academic thinking, has certainly been important, but the underlying problems of policy seem familiar.
Right now, we are in the midst of a very large unsettled question. Are the unprecedented Federal Reserve and other official interventions in financial markets a harbinger of the future? Is reasonable financial stability really dependent on such government support?
On the technical side, there has been continuing change in the approach of central banks to the market, away from more quantitative approaches like the volume of bank reserves to much more emphasis on precise control of short-term interbank interest rates. The point is that in establishing and conducting policy, you need some means of reaching operational decisions. Those approaches have differed and evolved. But none of that breaks new conceptual ground.
Stern: Well, let me explore that a little further because I happened to be reading some of the [Federal Open Market Committee meeting] transcripts from the 1970s, after the oil price shock but before you became chairman, so neither of us was at the meetings.
Volcker: Well, actually I was at the meetings from 1975 as president of the New York Fed.
Stern: Of course, right. So these transcripts were a little earlier in the '70s. Anyway, all the talk was about "cost-push" inflation and how monetary policy couldn't do anything about it. That was not only the consensus in the United States, but Federal Reserve officials who were traveling in Europe and talking with their counterparts heard the same message. Looking back at that from today's perspective, I think you'd be hard-pressed to find policymakers or economists who would accept that view.
Volcker: No, I think that's basically true. You know, the clearest articulation of that point of view was in Burns' farewell speech, "The Anguish of Central Banking," which was a long lament about how the Federal Reserve couldn't deal with inflation because of all the political and economic pressures, and wasn't that too bad. He made that speech at an IMF [International Monetary Fund] meeting about two months after I had become chairman.
So, when I gave my valedictory speech, I called it "The Triumph of Central Banking?" I put a question mark at the end. Somebody ought to write about this, how central banks became so important in the public mind and in their own mind in the past 10 years or so. Independence of central banking became part of the approach in almost every country. And I think you can make a case that it's been a little overdone, that central banks suffer from hubris, like everybody else.
Stern: I think that might be right, and I want to explore that a little bit, but I would say, you're personally responsible for that, because not only did you and your colleagues at the Fed succeed in bringing down inflation, but you did so when the general consensus was that nothing could be done about inflation, that we just had to live with it. So I think your success in bringing down double-digit inflation helped to establish the significance of monetary policy and central banks.
Volcker: You know, talking about whether economists have learned anything or contributed to monetary policy in the last several decades, Chairman Bernanke gave a speech at Princeton right after he took office which was an intellectual review of economists' views of monetary policy.
I don't recall all the substance of it, but he said basically that economists were ahead of central bankers in understanding important issues, going back to the 1920s and before and certainly in the Great Depression. But he went on to say that there was one area where the policymakers were ahead of the economists.3
It was an interesting comment. I don't know if he made it because he knew I was in the audience at the time. But he said something to the effect that the academic economists had to learn from central banking about the importance of maintaining a strong sense of price stability. He has translated that into inflation targeting, I guess.
The effectiveness of policy
Stern: You mention that you thought, maybe now, or certainly in the last 10 years, there was a point where we had too much confidence, too high a level of expectations for monetary policy. I've been thinking about that as well, because obviously we've had a very significant financial shock to the economy, and one of the consequences of that has been a long and deep recession, and high unemployment. You're familiar with all this. There seems to be a view that policy, both monetary and fiscal, can somehow fix this quickly. I guess I'm very uncomfortable about that.
Volcker: I don't think it can. I've been dealing with this in a political environment. The other day I'd gotten a paper prepared for the presidential advisory board that I'm the chairman of. It talked about housing and mortgages and so forth. It concluded, "We've got to do something to support housing," so it recommended means of spurring mortgage creation.
But then it went on, "We've got to do something to support consumption." There I begin to wonder. We can do something to support consumption, but are we really dealing with the underlying pressures in the economy without permitting a relative decline in consumption to proceed?
Stern: Right.
Volcker: It's not an easy question, if you try to explain that. Mr. Obama is out there every day having to explain things and would he say, "Well, I don't think I want to push a big stimulus on consumption"? I don't think he's about to say that, but he probably should be saying that.
Stern: The pressure seems to be now from the press I follow, "You've got to find policies that will create jobs," and again, who could object to that? But it's not obvious that there are a lot of tools that would be effective at that in the short run.
Volcker: No, I think this period we're going through is kind of a curative process; it's a purgative. There is something to the old view that you have to have a recession once in a while to deal with the excesses of a boom. And I think we had excesses in this boom, for sure, and we've got a really difficult recession. You want to relieve the sharp edges, without any question, but I don't think it's been possible to pump it up so there's no recession at all.
Stern: Yes, and part and parcel of recessions are resource reallocations. And we clearly had too many resources in housing and probably too many in finance and in autos—just to name three obvious places.
Volcker: Exactly. We need a recovery that emphasizes investment and competitiveness, and that ends or reduces our dependence on foreign borrowing. ... [Interview conducted July 15, 2009.]

links for 2009-09-16

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