Krugman reviews “This Time is Different: Eight Centuries of Financial Folly”

Krugman and Wells review of Rogoff and Reinhart’s new book This Time is Different: Eight Centuries of Financial Folly. Excerpts from the review below:

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[…] From an economist’s point of view, there are two striking aspects of This Time Is Different. The first is the sheer range of evidence brought to bear. Reading Reinhart and Rogoff is a reminder of how often economists take the easy road—how much they tend to focus their efforts on times and places for which numbers are readily available, which basically means the recent history of the United States and a few other wealthy nations. When it comes to crises, that means acting like the proverbial drunk who searches for his keys under the lamppost, even though that’s not where he dropped them, because the light is better there: the quarter-century or so preceding the current crisis was an era of relative calm, at least among advanced economies, so to understand what’s happening to us one must reach further back and farther afield. This Time Is Different ventures into the back alleys of economic data, accepting imperfect or fragmentary numbers as the price of looking at a wide range of experience.

[…]So what is the message of This Time Is Different? In a nutshell, it is that too much debt is always dangerous. It’s dangerous when a government borrows heavily from foreigners—but it’s equally dangerous when a government borrows heavily from its own citizens. It’s dangerous, too,when the private sector borrows heavily, whether from foreigners or from itself—for banks are basically institutions that borrow from their depositors, then make loans to others, and banking crises are among the most devastating shocks an economy can face.

[…]One odd omission by Reinhart and Rogoff, by the way, is their failure to mention the late Hyman Minsky, a heterodox economic thinker who made a similar argument and is now experiencing a renaissance in influence.

[…]The Depression looks much more like the product of excessive private-sector debt than like the government failure of monetarist legend.

[…]Financial crises are typically followed by deep recessions, and these recessions are followed by slow, disappointing recoveries.

(John Maynard Keynes, right, with US Treasury Secretary Henry Morgenthau Jr. at the Bretton Woods conference on postwar reconstruction, July 1944)

[…]It wasn’t until John Maynard Keynes offered a theoretical explanation of how it is that economies come to be persistently depressed—an explanation that was informed by historical experience but went far beyond a simple description of past patterns—that economists could offer useful advice to policymakers about how to fight a slump.

[…]The truth is that the historical record on the consequences of government debt is sufficiently ambiguous to admit of different interpretations. We read the evidence as supporting a policy of stimulate now, pay later: spend strongly to promote employment in the crisis, but take measures to curb spending and raise revenue once the crisis has passed. Others will see it differently. The main thing to notice, perhaps, is that there is no safe path: debt has long-term risks, but so does failing to engineer a solid recovery. The IMF’s research suggests that the long-term cost of financial crises is less when countries respond with strong stimulus policies, which means that failing to do so risks damage not just this year but for years to come.

[…]What the data show is a dramatic drop in the frequency of crises of all kinds after World War II, then an irregularly rising trend after about 1980, with a series of regional crises in Latin America, Europe, and Asia, finally culminating in the global crisis of 2008–2009. What changed after World War II, and what changed it back? The obvious answer is regulation.

[…]Why didn’t more people see this coming? One answer, of course, lies in Reinhart and Rogoff’s title. There were superficial differences between debt now and debt three generations ago: more elaborate financial instruments, seemingly more sophisticated techniques of assessment, an apparent wider spreading of risks (which turned out to have been an illusion). So financial executives, policymakers, and many economists convinced themselves that the old rules didn’t apply.

[…]Now that the multiple bubbles have burst, there’s obviously a strong case for a return to much stricter regulation. It’s by no means clear, however, whether this will actually happen. For one thing, the ideology used to justify the dismantling of regulation has proved remarkably resilient. It’s now an article of faith on the right, impervious to contrary evidence, that the crisis was caused not by private-sector excesses but by liberal politicians who forced banks to make loans to the undeserving poor. Less partisan leaders nonetheless fret over the possibility that regulation might crimp financial innovation, even though it’s very hard to find examples of such innovation that were clearly beneficial (ATMs don’t count).

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Esther Duflo on aid, development and RCTs

Was the 2008 financial crisis unprecedented?

Not at all! It would be a mistake to consider this crisis unprecedented and assume that "this time is different", according to a new report (particularly, see pp.11; this blog post is a summary of that section). For a discussion about growth in developing countries after the 2008 financial crisis, see this.

There were similar crises before: the US in the early 1990s during the Savings and Loans (S&L) debacle, costing 3% of GDP; Japan and Sweden in 1992; Mexico in 1994; Hong Kong, Indonesia, Malaysia, the Philippines, South Korea, and Thailand in 1997-98 (cost of bank restructuring: 50%, 25% and one-third of GDP in Indonesia, Japan and Thailand and South Korea respectively) ; Brazil and the Russian Federation in 1999; Turkey in 2000; and Argentina and Uruguay in 2002.

The 2008 crisis follows a pattern seen many times before. The pattern is captured by Hyman Minsky model.

1. In a successful capital economy, the financial structure abets enterprise but when finance fosters speculation the performance of a capitalist economy falters. Keynes defined enterprise as the "activity of forecasting the prospective yield of assets over their whole life" and speculation as the "activity of forecasting the psychology of the market."
2. Some exogenous event improves the prospects for profits, justifying speculative bets. Usually financial liberalization is followed by speculation as happened after the financial liberalization in Japan in the 1980s and in Sweden preceding 1992 crisis. The 2008 financial crisis was preceded by a significant increase in asset prices, fueled by leverage, low interest rates, and the perception that financial innovation had tamed financial risk.
3. Expectations take off, losing touch with reality. Euphoria, optimism, irrational exuberance, manias, bubbles, blindness to risk, animal spirits are some of the way to describe the psychological forces at work.
4. Credit system permits highly leveraged investments in the pursuit of socially valuable goods. But it also enables the pursuit of short-term capital gains in real estate, commodities or financial assets. Borrowers tend to progress from hedge finance (where the yield on an asset is sufficient to pay the interest and principal of the loan that financed) to speculative finance (where it is sufficient to pay only interest) to Ponzi finance (where the borrower is wholly dependent on capital gains).
5. A negative event triggers a reversal in the cycle. The greater the leverage, the more violent the downward journey. Prices fall and leveraged borrowers are unable to honor their debt.

Book review: Freefall: America, free markets, and the sinking of the world economy

[A review published in Trade Insight, Vol 6. No.1, 2010]

Joseph Stiglitz, a 2001 Nobel laureate in economics and a professor at Columbia University, had severely criticized the International Monetary Fund and the United States (US) Department of Treasury for their handling of the East Asian crisis in 1997, which cost him his job as Chief Economist at the World Bank. The global financial crisis of 2008, which he had predicted, has vindicated him of his incessant rant on and vilification of the “market fundamentalists” and their flawed models.

In his new book Freefall: America, Free Markets, and the Sinking of the World Economy, Stiglitz explains the causes of the Great Recession that started with the collapse of Lehman Brothers on 15 September 2008, exposes main players in the financial industry, berates the state of economics, and outlines what lies ahead for the global economy. Though the book is mostly about the US economy, it also contains interesting discussions about global economic challenges and their potential solutions.

He thinks that the unraveling of the causes of the global financial crisis is like "peeling back the onion", i.e., figuring out what lies behind each blunder. The markets failed because of the presence of large externalities, which in turn is caused by misalignment of incentives in the banking sector and information asymmetry in the asset market. Digging deeper would reveal that this was caused by blind faith in a flawed economic ideology about markets. He argues that “economics has moved—more than economists would like to think—from being a scientific discipline into becoming free market capitalism's biggest cheerleaders". Dancing to the tune of the market cheerleaders, the people responsible to oversee the financial industry either failed to see the crisis coming, or did nothing to stop it when warned, or did too little too late when the downward spiral began.

An advocate of a Keynesian fiscal stimulus to overcome the adverse impact of the economic crisis, Stiglitz is dissatisfied with the structure, size and progress of US President Barack Obama’s stimulus package. An ideal stimulus is fast; effective in increasing employment and output; addresses long-term problems such as low savings, trade deficit, social security and infrastructure; investment-oriented; fair (relief for the middle-class, not the richest 5 percent); deals with short-run exigencies (insurance and mortgage payment); and targets job loss ( to retain skills and workers). Australia was the first country to design a stimulus package in line with these principles, and, no wonder, the first advanced country to emerge out of recession.

Stiglitz advocates a second round of stimulus in 2011 and a redistribution of income with progressive taxation in the US. He advises the US government not to "give into deficit fetishism" because as long as returns on investment in technology, education, and infrastructure are greater than the size of the deficit, it should not be a problem to roll out another stimulus. He also pitches for a coordinated global stimulus as global multiplier is greater than national multipliers.

The world has to address, argues Stiglitz, six economic challenges: (i) mismatch between global demand and supply; (ii) climate change because environment prices are distorted, leading to unsustainable use of resources; (iii) global imbalances due to excess consumption in advanced countries and excess savings in developing countries; (iv) manufacturing conundrum because there is increase in productivity but decrease in employment; (v) inequality because it is affecting overall aggregate demand as there is more money with the rich and less with the poor; (vi) and growing financial instability leading to unmanageable risks.

These challenges call for a new economic model, which should include a bigger role for government. It is the government's responsibility to ensure that errant markets do not lead to catastrophic social and economic situations. It should play a critical role in maintaining full employment and a stable economy; promoting innovation; providing social protection and insurance; and preventing exploitation by “correcting” market distortion of income distribution.

Stiglitz censures economists who pushed their model of rationality beyond its appropriate domain and blasts inflation-targeting ideology, predicting that it will die after this crisis. Even if this ideology persists, the crisis has revealed the limitation of markets and resurrected Keynesian economics. Indeed, “the fall of Lehman Brothers may be to market fundamentalism what the fall of Berlin Wall was to communism”.

The Sinking of World Economy_Trade Insight 2010

Post-crisis trade recovering (but not fast enough)!

Merchandise trade volume grew in the Q4 2009 in the G7 countries, albeit at a slower pace than in Q3 2009. Though trade volumes and values have recovered since the plunge in Q3 2008 and Q1 2009, their level is still below the pre-crisis levels of mid-2008 (by almost 20 percent lower to pre-crisis level). Import and export volumes from G7 countries rose 3.1% and 3.9% respectively. The more rise in imports by G7 countries, the better is the chance of developing countries benefiting from the trade recovery, assuming that majority of imports by G7 countries come from the developing countries!

 
 Here is real GDP figures (see the plunge!)

Industrial policy is back: Rodrik

Rodrik argues industrial policy was never dead! Successful economies always used it.

British Prime Minister Gordon Brown promotes it as a vehicle for creating high-skill jobs. French President Nicolas Sarkozy talks about using it to keep industrial jobs in France. The World Bank’s chief economist, Justin Lin, openly supports it to speed up structural change in developing nations. McKinsey is advising governments on how to do it right.

Industrial policy is back.

In fact, industrial policy never went out of fashion. Economists enamored of the neo-liberal

Washington Consensus may have written it off, but successful economies have always relied on government policies that promote growth by accelerating structural transformation.

The shift toward embracing industrial policy is therefore a welcome acknowledgement of what sensible analysts of economic growth have always known: developing new industries often requires a nudge from government. The nudge can take the form of subsidies, loans, infrastructure, and other kinds of support. But scratch the surface of any new successful industry anywhere, and more likely than not you will find government assistance lurking beneath.

Ten bad ideas for economic growth

It comes from a recent report about post-crisis growth and developing countries by the Growth Commission. The set of bad ideas for growth are:

1. Assuming the crisis is a “mean-reverting” event and the we will return to a pre-crisis pattern of growth, capital costs, trade and capital flows.
2. Interpret the need for better regulation and government oversight of the financial sector as a reason for micromanagement of the financial sector.
3. Abandon the outward-looking, market-driven growth strategy because of financial failures in the advanced countries.
4. Allow medium-term worries about the public debt to inhibit a short-term fiscal response to the crisis.
5. Adopt counter-cyclical fiscal policies without concern for the returns on public spending, and without a plan to restore the public finances to a sustainable path over time, once the crisis is past.
6. Ignore the need for more equitable distribution of gains and losses in periods of prosperity as well as in crisis.
7. Continue with energy subsidies on the assumption that commodity prices will not rebound after the crisis.
8. Treat the financial industry like any other, ignoring its external effects on the rest of the economy.
9. Focus monetary policy on “flow” variables like inflation, job creation and growth, ignoring potential sources of instability from the balance sheet (asset prices, leverage, derivates exposure).
10. Buy assets whose risk characteristics are hard to understand. The high returns are likely to reflect higher risk even though the latter may be hidden from view. They will be overpriced and salable, if at all, in a crisis only at distressed prices. Things that seem too good to be true, probably are.