Since DeLong did not link to or mention my post, I doubt his piece had anything to do with mine. But his post is noteworthy for a completely different reason: it illustrates how economists have refused to learn much, if anything, from the crisis. And in some ways, I feel bad about taking DeLong to task on this. He’s been far more willing than the overwhelming majority of mainstream economists to admit how seriously he and the profession got things wrong. And yet he seems unwilling or unable to look hard at conventional thinking in the discipline and free himself of it. DeLong and his colleagues are proving Thomas Kuhn right (I confess to liking Max Planck’s formulation, “Science progresses funeral by funeral.”)
DeLong nevertheless puts up a straw man from Klein’s post that we addressed in our takedown. Klein argued that the crisis was “scary” and continued:
The complexity of the system far exceeded the capacity of the participants, experts and watchdogs. Even after the crisis happened, it was devilishly hard to understand what was going on.
To the extent it has been hard to figure out what happened (and I submit that the mechanisms that turned what would otherwise have been a contained subprime meltdown into a global financial crisis actually are not that hard to understand), it is because the perps and the regulators have made sure some of the key drivers have not been investigated and continue to be opaque and complex, which allows the financial services industry to continue looting. For instance, it is simply inexcusable that after the collapse of Bear Stearns that there was not a full bore coordinated effort among international regulators to get to the bottom of credit default swaps exposures (CDS were the reason Bear, a firm that most would have judged to be non-systemically important, was rescued).
But who is doing what to whom in the CDS market still continues to be a mystery, even though the AIG bailout made it clear that it would be government backstopped and hence is a matter of public interest. Indeed, one of the reasons presented by Angela Merkel, among others, for why Greek debt can’t be restructured is the bugaboo of the CDS exposures. They’ve now become a preferred vehicle for holding governments hostage, which server the big end of the banking industry just fine.
In general, the failure to have regulators to demand data from the major banks and do decent post mortems is a mind-boggling dereliction of duty. At a minimum, every bank that took money from the authorities should have been required, as UBS was, to bring in independent experts and produce a report of why they screwed up so badly that they wound up on life support. That wouldn’t be comprehensive, but it would have provided a foundation for further investigation (and cross checking the explanations would have been intriguing).
Back to DeLong. He takes up a spurious argument that Klein used, that someone has to have predicted how the crisis would unfold in considerable detail to get credit for getting it right, and that it is necessary to meet that standard to ward off future crises. This was Klein’s argument:
Some people managed to connect the right dots, in the right ways and at the right times, but not so many, and not through such reproducible methods, that it’s clear how we can make their success the norm.
We described why that was an unreasonably daunting standard (you just need to be able to project that trends in motion are going to produce very bad outcomes, and not the particular path they will take), and that there are measures that could be taken now that don’t require near magical degrees of foresight to reduce the risk of future blow-ups considerably. And in the bad old days, when regulators weren’t cowed by banks, they were willing to knock heads when leverage levels got out of line. In the 1970s, the Fed spoke to the major Wall Street players and told them to quit arranging leveraged takeovers, or There Would Be Consequences. In 1987, Treasury announced that it was considering taxing highly leveraged transactions as a warning shot across the industry’s bow (some have contended that that move was one of the triggers of the 1987 crash, but Robert Shiller’s research has disproven that belief).
But DeLong does not merely follow Klein’s spurious logic; he also raises the bar. He implies that someone had to be able to predict “where we are now” (which is not at all the same as seeing as of early 2007 that Things Were Going to End Badly, probably Really Badly). Huh? The objective of this exercise is to figure out how to substantially reduce the odds of the really awful event of a global financial meltdown, not to predict single precise endpoints at the end of a long sequence of decision and event nodes. So the goalposts have now been moved onto an entirely different playing field.
But his list of what he thought you had to see to anticipate where we are now gave me real pause. DeLong can’t even come up with a good tally of drivers in retrospect:
1. That a global savings glut and a period of low interest rates would produce a housing boom.
2. That the housing boom would turn into a housing bubble.
3. That the housing bubble would lead to a collapse of mortgage underwriting standards.
4. That risk management practices on Wall Street would have been nonexistent.
5. That the Federal Reserve would not be able to construct its usual firewall between finance and the real economy.
6. That the Federal Reserve would not feel itself empowered to take the emergency steps to stabilize demand needed during and in the immediate aftermath of the financial crisis.
7. That the incoming Obama administration would come out of the gate with too small an economic recovery package.
8. That politics would prevent the Obama administration from being able to take a second bite at the apple.
9. That the Obama administration would then give up on pushing the envelope of its powers to try to generate a strong recovery.
10. That the intellectual victory of Keynesian approaches on the level of reality–forecasting and accounting for the course of the Little Depression–would be accompanied by a non-intellectual defeat of Keynesian approaches on the level of politics.
On 1-3, we’ve debunked the global saving glut thesis on empirical grounds. First, the average global savings rate over the 24 years ending in 2008 was 23%. It rose in 2004 to 24.9%. and fell to 23% the following year. It seems a bit of a stretch to call a one-year blip a “global savings glut”. Second, credit growth in the US was well out of proportion to what can be explained even by the massive growth of foreign exchange reserves in China and other Asian trade partners.
The Bank of International Settlements provides further ammo in support of our view. The abstract of a May 2011 paper (hat tip Richard Smith) by Claudio Borio and Piti Disyatat (note that Borio, along with William White, was warning central bankers before 2003 of the dangers of the rise in global housing prices, so since Klein and DeLong seem to value prescience, they might pay heed to him):
Global current account imbalances have been at the forefront of policy debates over the past few years. Many observers have recently singled them out as a key factor contributing to the global financial crisis. Current account surpluses in several emerging market economies are said to have helped fuel the credit booms and risk-taking in the major advanced deficit countries at the core of the crisis, by putting significant downward pressure on world interest rates and/or by simply financing the booms in those countries (the “excess saving” view). We argue that this perspective on global imbalances bears reconsideration. We highlight two conceptual problems: (i) drawing inferences about a country’s cross-border financing activity based on observations of net capital flows; and (ii) explaining market interest rates through the saving-investment framework. We trace the shortcomings of this perspective to a failure to consider the distinguishing characteristics of a monetary economy. We conjecture that the main contributing factor to the financial crisis was not “excess saving” but the “excess elasticity” of the international monetary and financial system: the monetary and financial regimes in place failed to restrain the build-up of unsustainable credit and asset price booms (“financial imbalances”). Credit creation, a defining feature of a monetary economy, plays a key role in this story.
And in 1-3, DeLong also has the causality backwards: the fall in underwriting standard preceded and helped produce the bubble. It was the result of an ugly combination of the bad incentives produced by securitization and deregulation, turbo charged by the mortgage-industrial complex’s increasing clout in DC, which led to more subsidies and aggressive efforts to beat back every effort to promote more responsible behavior. The new Gretchen Morgenson/Josh Rosner book Reckless Endangerment chronicles in gory detail how the decline in standards and safeguards considerably antedate the bubble.
As to 4, that Wall Street has not much in way of risk management, that just proves one of my chief beefs about economists: their distaste for research, particularly the qualitative kind. Had DeLong and his ilk spoken to a few people who understand how these firms work, they could easily have disabused him of that notion. This discussion, for instance, is from Richard Bookstaber, author of A Demon of Our Own Design, who headed risk management at Morgan Stanley:
…the risk manager is always at a disadvantage when dealing with the trading desk.
First, the traders obviously know their market better than the risk manager can ever hope to. So if a concern gets elevated to the point of an us-versus-them debate with the traders on one side and the risk manager on the other, the traders will be able to run circles around most risk managers…
Second, for each blowup that occurs, there will be ten cases where there was a legitimate concern but nothing happened. That is, if measured based on the realized outcome, the odds are the risk manager will be wrong more often than he is right. So there is the risk of looking like the boy who cried wolf.
Another point which is not expressed in the set of conversations above is that in most large firms the risk manager makes himself too busy to really focus on risk management. If he lets himself get sucked into making the role look weighty, he will end up spending his time running an organization, worrying about having adequate face time with senior management, and elbowing his way into all the right meetings.
By the way, Bookstaber published that at the beginning of December 2007, so this is not a post crisis reassessment. And he didn’t include the fact that the staff and managers in risk management are less well paid than traders, so they have every reason to try to curry favor with them rather than be tough if they think they might be able to jump the fence.
Let’s go to 5, ” Federal Reserve would not be able to construct its usual firewall between finance and the real economy.” This isn’t clearly drafted, but I think he means that the monetary policy should be able to buffer the real economy effects of abrupt moves in the financial markets. But Keynes debunked that, although that has been excised from macroeconomics since its implications are disastrous to the equilibrium theories to which the economics profession has become addicted. He discussed that when liquidity preferences change (less politely, when investors freak out and run for safe havens) making money cheaper is not going to induce a shift in behavior. The Fed has done a ton more than that, but its creative measures now look an awful lot like pushing on a string.
As to 6, which argues the Fed should have tried to goose the economy, Keynes again argued otherwise (I know some readers hate the idea of stimulus, but put that aside, we are discussing the efficacy of various paths to that end). Businessmen won’t invest or hire more people just because monetary conditions are lax; they need to feel their is a realistic prospect that their risk-taking will bear fruit. I’ve never been happy with this, “Well if we can’t provide enough/any fiscal stimulus, let’s let the Fed do what it can” posture. Not only is this certain to be somewhere between minimally to not effective (save in boosting our export sector by depreciating the dollar, but we can’t go very far down that path without inducing protectionist responses), with the dollar as one of the preferred vehicles for carry trades, it has perverse effects on other economies (among other consequences…).
The rest of DeLong’s points are political rather than economic.
Even though I’m sure this was a throwaway post, it’s still disconcerting to seem someone as smart as DeLong opine confidently about the crisis yet go so wide of the mark.
Now since DeLong has aligned himself with Klein’s argument, it is all too easy to see them both as So Loyal to Team Dem that They Will Take a Bullet for Bad Causes. Klein, as we pointed out, has staunchly defended some of the worst warts in the Obama health care plan; DeLong, among other things, can be relied upon to protect Larry Summers’ back. In fact, a DeLong defense of a Summers Financial Times op-ed led to our first row conversation.
But I see a big difference between the two of them. Even though I question DeLong’s views, he seems in large measure to be a prisoner of the way the economics frames problems and its peculiar approach to what little the discipline does in the way of empirical research (this is a long-standing problem; Nobel Prize winner Vassily Leontief quit doing any kind of economic research out of his frustration on this very issue). And he is further disadvantaged by being on the wrong coast to have much interaction with the sort of bankers that played a role in the crisis. DeLong’s failings, in other words, are largely those of imagination.
It’s harder to imagine, by contrast, that Ezra Klein does not know better. His arguments are often so strained and specious that he can’t not recognize that they are exercises in porcine maquillage. And his reaction to Inside Job was a tell. The movie put corruption front and center as a cause of the crisis, and that seemed to evoke a visceral response from Klein, who resorted to a new version of the “whocouldanode” defense. As gregw571 wrote in the comments on Klein’s post:
Here’s the deal, Ezra, the world in which you averted your eyes to in “Inside Job” is the world you write about everyday.
The perverse incentives (groupthink, peer pressure, the tribalism of DC, tribalism of Wall Street, the revolving door, regulatory capture, the go along to get along, don’t burn sources, don’t make waves, do the bidding of Wall Street because an election is coming up, don’t have a transaction tax for fear of appearing to be anti-business or anti-Wall St., don’t regulate derivatives for fear of appearing to be anti-business or anti-Wall St.) they are in play in 2011 the way they were in 04, 05, 06, 07, 08, 2009, 2010. Ferguson described your world and you don’t like it…
DC is corrupt, the financial and cultural incentives are to get it wrong.
But in the end, differences in character may not make all that great a difference in outcomes. With the economics discipline in in the thrall of a dubious orthodoxy, we put ourselves at risk if we place our trust in them.
This post originally appeared at naked capitalism and is reproduced here with permission.
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