Lecture: Seven Sects of Macroeconomic Error, Part I
J. Bradford DeLong
The Right Explanation for Our Great Recession
Let me briefly review the right explanation for our Great Recession: the explanation that I been pushing in the past several weeks of the course, since we finished the "economic growth" section of the course. The right explanation of our Great Recession is that the downturn had three sources. First comes irrational exuberance in housing markets. Irrational exuberance in housing markets led to a substantial number of mortgage loans being made that should not have been made. These loans would not have been a problem if you had had capital market arrangements like we had in the late 1990s during the dot-com boom. The dot-com boom also saw irrational exuberance, much more irrational exuberance, in fact, than we saw in the subprime mortgage bubble.
But irrational exuberance in the dot-com boom was not accompanied by overleverage. The venture capital firms that created and issued the securities of the dot-com boom sold them off to unleveraged primary investors, rather than leveraging up and holding on to them by financing their positions with borrowed money. When the dot-com crash came, high-net-worth individuals lost their wealth. But there were no large money-center banks whose solvency was thrown into doubt by the crash.
Things were different with the subprime crash. The large money-center investment and commercial banks found, after the crash, that the losses on their subprime mortgage holdings were of the same order of magnitude as and might exceed their capital cushion. Their other liabilities were thus no longer beyond question--perhaps the money-center banks were not good to pay back all their creditors and make good on all of the deposits they had accepted. This was, in large part, the result of the third factor: misregulation--the government had failed to impose and maintain proper capital adequacy standards of those banks that were indeed "too big to fail"; the government had failed to use its regulatory hammer to check whether the large money-center banks possessed the proper risk controls. It turned out that they did not: that the top managements of the money center banks had no idea of the risks that their subordinates were running on their shareholders' behalf.
The consequence was panic and flight to quality. A huge tranche of financial assets that had been generally classified as safe turned out not to be so. These tranches had been places to put your money where you could sleep easy, confident it would still be there when you came back for it. That was the whole reason for you to invest in a AAA mortgage-backed security rather than in something riskier that offered a higher return.
So what happened when it became clear that the supply of high-quality financial assets was a lot lower than people had thought? What happened when it became clear that a larger value of assets labeled AAA were not so? What happened when all of those debts that were thought to be of high quality because those owing the debts owned AAA assets turned out to be not such high quality at all because the assets backing those debts were not AAA? And what happened when it became clear that the ability of financial professionals to properly understand their risks had been greatly oversold? A collapse in the supply of high-quality financial assets accompanied by a surge in demand.
This fall in the supply and rise in the demand for high-quality assets created an enormous financial market imbalance. The counterpart to this large excess demand for high quality assets was deficient demand for currently-produced goods and services and labor--a "general glut." People who felt that their portfolios were short of high-quality assets cut back on their spending to try to build up their high-quality asset stocks. But when they and everyone else cut back in spending, all they managed to do was to cut back on sales, employment, and income. They found that their cut back on spending was matched by a fall in their incomes so that they did not manage in fact to build up their stocks of high-quality assets. And as total spending fell short of the amount needed to provide full employment the economy headed into recession.
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The Right Cure for Our Great Recession
That was the cause. What is the proper cure for our current macroeconomic distress, for our Great Recession? The cure, I said, had three parts.
The first was regulatory reform. Beef up the regulatory and supervisory structure so that this won't happen again, or at least so that this will be less likely to happen again. Repair the defects of regulation that allowed banks to get themselves into this absurd position. Repair current overleverage. Attempt to ensure that in the future bankers will notice when they get overleveraged. And be sure that they fear that if they get overleveraged and a crash comes then they are going to suffer both in their personal pocketbooks and in the bankruptcy of the institutions they head. If there were a plausible regulatory reform that would successfully curb irrational exuberance on the part of savers and investors we would undertake that as well. That, however, is a much harder task: we economists have not advanced very far. Regulatory reform is this the first prong of the cure.
The second prong is that, while we are waiting for regulatory reforms to take effect--if they are going to take effect--we want to repair the shortage of aggregate demand and return the economy to full employment. The second prong is to use government spending to restore full employment. Have the government stand up its spending when private sector stands down its spending. This is expansionary fiscal policy. There is, because of the excess demand for high-quality financial assets, not enough demand for currently-produced stuff? Then the government can go buy more stuff.
The third prong is the other way that policy can affect the level of aggregate demand in the short run. Have the government carry out strategic interventions in financial markets to rebalance them. Excess demand for financial assets is driving deficient demand for currently-produced goods, services, and labor? By Walras' Law, eliminate the excess demand for financial assets and you will have rebalanced the goods markets as well. The government can provide the private sector with the financial assets that it wants and and cannot find. When the private sector has the financial assets that it wants, then asset prices will go back to normal. There will no longer be this elevated long real risky interest rate which has put so much downward pressure on investment spending.
These strategic interventions in financial markets can be carried out through any of a large number of possible mechanisms. Milton Friedman was certain that the only mechanism you needed was standard open-market operations--purchases and sales of short-term Treasury bonds for cash--and that the right policy to follow was one that kept the economy-wide money stock on a smooth growth path. We are not no certain.
One strategic intervention is to create more savings vehicles, either by creating more government bond directly via additional deficit spending or through inducing the creation of more private bonds. Deficit spending by government--and subsidization policies like investment tax credits to encourage private investment by businesses, or even jawboning to create expectations of a little more inflation in order to boost private bond issues--create more savings vehicles, more places for people to park their money if they want to move it from the present into the future. To the extent that the excess demand in financial markets is an excess demand for duration, the creation of more such savings vehicles is exactly the right thing to do.
A second strategic intervention is that the Federal Reserve can buy back bonds from the private sector for cash, and so increase the amount of liquid cash money in the economy. If the excess demand in financial markets is an excess demand for liquid cash money, this is exactly the right thing to do.
A third set of strategic interventions is more mushy and diffuse. The Federal Reserve and bank regulators together can guarantee bank debt. They can take risk onto their own books by a whole host of what we now call "quantitative easing" measures--the purchase not just of short-term safe nominal assets but risky assets. They can boost not the supply of savings vehicles or the supply of liquidity but rather act to reduce the demand for and increase the supply of safety in financial markets. And since the principal origin of our problem was in the flight to quality and the resulting excess demand for safety, it would be appropriate to take this as the principal focus of policy right now.
In any event, when there is no excess demand at full employment for financial assets, there won’t be any downward pressure on production and employment. That stopped the downturn. To generate a recovery we need to do a little bit more: create an excess supply of financial assets in order to generate an excess demand for currently-produced goods, services, and labor. But we have not advanced far along that road yet.
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Excess Demand for Financial Assets and the Income Expenditure Framework
We formalize all of these considerations in the investment-savings version, the IS version, of our income-expenditure framework. It tells us what the level of real GDP in the economy will be as a function of:
- the factors that determine the multiplier--the tax rate, the marginal propensity to consume, and the marginal propensity to import.
- the economic environment--foreign levels of GDP, foreign interest rates, and the confidence of consumers, businesses thinking about undertaking investment projects, and foreign exchange speculators.
- fiscal policy--government purchases.
- monetary policy and financial markets--the determinants of the long-term risky real interest rate, which we parcel into four:
- the short-term safe nominal interest rate.
- the duration premium.
- the risk premium.
- the expected inflation rate.
We write the key equation of the investment-savings version of the income expenditure model as:
Y = μ[A0 + G + (Ir+Xεεr)r]
μ = 1/[1 - (1-t)cy + imy] being the multiplier, depending on the tax rate, the marginal propensity to consume, and the marginal propensity to import
A0 being baseline autonomous spending, depending on foreign incomes, foreign interest rates, and the confidence of consumers, business investment planning committees, and foreign exchange speculators
G being government purchases--fiscal policy
Ir being the interest sensitivity of investment
Xεεr being the interest sensitivity of exports--the product of the exchange-rate sensitivity of exports and the interest sensitivity of the exchange rate
r being the long-term, real, risky interest rate.
It is true that the root problem was a derangement in the subprime mortgage market resulting from irrational exuberance which then triggered a derangement in financial markets more generally due to overleverage and misregulation.
But we could fix mass unemployment without tackling the fundamental roots of the downturn. We just have to pull the fiscal, monetary, and banking policy levers in such a way as to get aggregate demand back to where it should be. We can then clean up the financial mess later on. Job number one, after all, is to cure mass unemployment rather than to fix the fundamentals of the financial system.
This is the right model for the cause and cure of the Great Recession.
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Am I Right?
But if you go outside of this classroom out there into the great political-economical debate, into the scrum, you will find that this position that I have been pushing in this course--while it is certainly the dominant position, the plurality position, the position held by the overwhelming majority of most qualified experts--it is by no means the only position out there. I say that our problem is that misregulation, excess of leverage and irrational exuberance produced the financial crisis which then led to an aggregate demand shortfall that we should repair as fast as possible by properly-stimulative fiscal, monetary, and banking policies. But there are others whom you will find saying at least seven different things.
So in the rest of this lecture section, let me run through the wrong models of the current downturn and what we should be doing about it--and let me explain why all of these alternative positions are wrong.
Let me note that I find this to be a very awkward position to be in. There is my karass of economists--sensible, reality-based, empirically-oriented, understanding reality. And there are seven other factions and schools of economists out there saying very different things--things very different from what I am saying and from what all the other economists who I believe are carrying out sensible analyses are saying.
I firmly believe that I am right.
I firmly believe that I am right almost as firmly as I believe that the sun will rise in the east tomorrow.
Of course, there was the day...
I was flying back from Europe during northern hemisphere winter. We came out of the earth's shadow into the sun somewhere north of Manitoba at local noon--so the sun was due south of the plane as we flew into daylight. From the plane, on that day the sun rose in front of us directly to the south.
Thus it is not certain that the sun is always going to rise in the east. In fact, I have seen it do otherwise. Admittedly, I have seen it only in very special circumstances: 30,000 feet up, flying due south out of the earth's shadow during northern hemisphere winter, and at local noon.
That is an important lesson: no matter how certain you are that you are right, you could be wrong.
Nevertheless, I will proceed...
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Why the Seven Sects of Error? The Role of Milton Friedman
The first question I want to address is: why are so many people--smart people--holding on to these wrong models? And here I blame the late Milton Friedman, longtime professor at the University of Chicago, head of the Chicago School of Economics before he developed some sense and moved to San Francisco. I blame Milton Friedman because he made things much much too simple.
Milton Friedman thought that it was sufficient simply to keep the money stock on a stable growth path--that that was the only set of strategic interventions in financial markets necessary to ensure constant full employment. Why did he think this? I believe that there are two reasons. The first was that if you look from say 1980 or so back into the past, the times when the money stock is unstable are the times when there are depressions. The times when the money stock is stable are times when there are no depressions. You could argue whether instability in the money stock was cause or effect of depressions. Milton Friedman thought that instability in the money stock was cause. Others thought it was the effect. They argued back and both. It was not clear. Of course, it is clear now: because the Federal Reserve tried successfully to prevent a decline in the money stock in 2008, it is now clear to us that much of past money-demand correlations arose because when demand fell the banking system came under pressure to shrink the money stock.
If there were good arguments on both sides, what made Friedman so certain that instability that the money stock was the cause and not the effect? I think the answer is that he was a committed libertarian. He was not just an economic libertarian--not just a believer that the government shouldn’t be interfering in the marketplace in prices and quantities and property rights. He was a social libertarian. He was a believer that the government should not be sticking its nose into people’s bedrooms, or into their ideas about how to pursue better living through chemistry. He wanted to say that that government is best that governs least: establish property rights, set up some courts to decide things if people dispute, otherwise just get out of the way--don't interfere with market prices or market quantities or property rights or social mores, but get out of the way in order to maximize individual liberty.
The problem is that this does not fit with macroeconomics. We have this circular-flow income-expenditure system in which there are always these excess demands for and excess supplies of financial assets emerging. They carry with them either high unemployment or inflation. And so the government is always having to intervene to rebalance financial markets to avoid mass unemployment or inflation.
Now that is not a terribly terribly comfortable position for a libertarian to be in. The government is constantly intervening in the money market: buying and selling bonds and cash in order to soak up whatever excess demand or excess supply exists in financial markets. How is this a hands-off, libertarian, laissez-faire policy?
At this point Friedman could have done either of two things. He could have said: libertarianism is true always and everywhere except for monetary economics, where the rules are different. He could have found a way to make his preferred government monetary policy sound like laissez faire.
He chose the second. He said that the right monetary policy is for the government to keep its hands off of the money stock--for the government to follow a non-interventionist policy of letting the money stock grow at a constant rate and not intervene in financial markets to push the money stock up or down. It is a bright-line rule. It should be easy to follow. I would say that it is not "non-interventionist": whenever something happens to the banking system to make banks want to diminish their ratio of deposits to reserves, the Friedman rule requires that the Federal Reserve not keep its hands off the economy but rather that it go into the market and buy a huge amount of bonds. Why is a constant money growth rate rule a "laissez faire" "non-interventionist" policy? It isn't--any more than a constant kwh growth rate rule or a constant steel production growth rate rule is a "laissez-faire" "non-interventionist" policy. But these are not questions Milton Friedman wanted to answer, or even wanted to hear asked.
Instead, Friedman said: keeping the money stock growing at a constant rate is a neutral, non-interventionist, laissez-faire policy. Forget about what all the Keynesians over there are saying about more complicated strategic interventions. Constant M growth is the rule.
And so Milton Friedman acquired a lot of followers behind this constant money stock growth rule. But starting in the 1980 it becomes apparent that it’s simply not true. Central bankers tried to follow Milton Friedman prescriptions. And they found themselves getting into trouble. And lo and behold in 2008 they got into big trouble, when extraordinary increases in the monetary base did not keep unemployment from rising and kissing 10%.
Here Friedman's followers and their intellectual descendants found themselves trapped by the rhetorical strategy Friedman had adopted in the 1950s and 1960s and 1970s. Friedman believed that macroeconomic stabilization required that the central bank be always in the market, buying and selling government bonds in order to match the supply of liquid cash money to the demand, and so make Say's Law true in practice even though it was false in theory. And Friedman tried to maximize the rhetorical distance between his position--which was merely the "neutral," passive policy of maintaining the money stock growth rate at a constant--and the position of other macroeconomists, which was an "activist," interventionist policy of having the government disturb the natural workings of the free market. Something went wrong, Friedman claimed, only when a government stepped away from the "neutral" monetary policy of the constant growth rate rule and did something else.
It was, I think, that description of optimal monetary policy--not "the central bank has to be constantly intervening in order to offset shocks to cash demand by households and businesses, shocks to desired reserves on the part of banks, and shocks to the financial depth of the banking system" but "the central bank needs to keep its nose out of the economy, sit on its hands, and do nothing but maintain a constant growth rate for the money stock"--that set the stage for what was to follow, and for what we see now among the seven sects of macroeconomic error that I am taking an unconscionably long time in getting to.
Friedman's rhetorical doctrine was successful in eliminating the perception of cognitive dissonance between normal laissez-faire policies and optimal macro policy: both were "neutral" in the sense of the government "not interfering" with the natural equilibrium of the market. But it did so at the cost of eliminating all interesting macroeconomic questions: if the government followed the proper "neutral" policy, then there could be no macroeconomic problems. And it left his intellectual descendants with no way to think about these issues: generations of Chicago that had been weaned on this diet turned out to know nothing about macro and monetary issues when they became important again.
It is in this sense, I think, that I blame Milton Friedman: he sold the Chicago School an interventionist, technocratic, managerial optimal monetary policy under the pretense that it was something--laissez-faire--that it was not.
And then it turned out at the end of 2008 that it simply did not work.
Now at this point the seven sects of macroeconomic error could have done either of two things. They could have chosen wisely. They could have said: "Oops we’ve been followers of Milton Friedman for 50 years and we were wrong, his intellectual opponents were right. We have to go back and listen to them and learn what they had to say and change our minds. We need to sit at the feet of Bagehot and Wicksell and Minsky and Keynes and Hicks and Tobin for a while and think through the issues of the determinants of aggregate demand.
They chose not wisely. They chose to say: "Milton Friedman taught us that the Keynesian version of the income-expenditure approach was wrong. There is something wrong with Friedman's theory. But we need to develop it and add something new rather than return to something old and discredited."
It turned out an awful lot of economists decided to follow the second road--that of becoming Ptolemaic astronomers, of trying to add epicycle after epicycle, adding eqants and deferents, and so forth to try to save the phenomena. And they did so even though the standard story of demand shortfall-driven recessions that dated back to 1829 and that in fact underpinned Friedman's version of monetarism was still in good shape, and still perfectly adequate.
That story leaves me highly confident that all seven of the alternative models are wrong. I understand how it is that people--smart people, even if not wise people--arrived at them. And I also understand why they are wrong.
But the explanation of why they are wrong must wait until next time...