Grant Gilmore on Teaching: Spies in an Alien Land
David Frum: What Does Paul Ryan Think He Is Doing?

Global Risks: How Did We Get Here?

I should start by setting out the things I believed in three or four years ago that now appear to be wrong.

First, I thought that the highly leveraged banks had control over their risks. With all of the industry's experience at quantitative analysis, with all our knowledge of economic history, with bosses who understood the importance of walking the trading floor--I thought that our commercial and investment banks were professionals at risk management.

But our highly-leveraged banks and shadow banks did not have control over their risks. Indeed if you read the documents from the SECs case against Citigroup for its 2007 earnings call, Citigroup did not know what their subprime exposure was and had a frackingly difficult time finding out. Managers seem to have genuinely thought that their underlings were following the originate-and-distribute business model they said they were. Back when Lehman Brothers was a partnership, every 30-something in Lehman Brothers was a risk manager because they all knew that their chance of becoming really rich depended on Lehman Brothers not blowing as they rose their way through the ranks. But if the high-fliers' bonuses are based on the mark-to-model performance of their positions over the past 12 months, you've lost that every-trader-a-risk manager culture. I thought the big banks knew this, and had compensated for it.

I was wrong.

Second, I thought that the Federal Reserve had the power and the will to stabilize the growth path of nominal GDP. He was not called "Helicopter Ben Bernanke" for no reason. When demand for currently-produced goods and services is crashing because households and businesses find themselves desperately short of the safe, liquid vehicles of appropriate duration in which they want to park their wealth and so are not-spending in order to build up their safe, liquid, appropriate duration asset holdings, it is the job of the central bank--and of the Treasury through banking policy, and perhaps of the Treasury through fiscal policy--to fix it and give the private sector the financial assets it wants. No excess demand for financial assets, and by Walras's Law there can be no deficiency of demand for currently-produced goods and services and labor in general.

How government can intervene strategically in financial markets to stabilize nominal GDP has been the subject of a lot of work--Tobin, Friedman, Kindleberger, Minsky, Hicks, Keynes, Fisher, Wicksell, Bagehot, John Stuart Mill. The government provides liquidity, safety, and duration by guaranteeing stuff and by buying stuff and issuing its own liabilities in return. The government has to, as Bagehot put it, "lend freely"--and not just lend but buy--and in order to avoid enabling moral hazard for the next time the government has to lend at a penalty rate: and if institutions are not illiquid but insolvent so that the government cannot lend at a penalty rate the government must take equity.

Demand management worked in spite of a number of large shocks from the mid-1980s to the mid-2000s. Black Monday in 1987. The S&L crisis of 1990. The Mexican peso crisis of 1994. The East Asian crisis of 1997. The Russian state bankruptcy. LTCM. The collapse of the dot-com boom. Assorted Brazilian, Turkish, Argentinian, and other episodes. In all these the Federal Reserve, without breaking a sweat, intervened strategically in financial markets to successfully build a firewall between financial panic and distress on the one hand and effective demand for goods, services, and labor on the other. And so we all began writing papers on the "Great Moderation."

I remember 2005. The worry was the potential for a dollar crisis. That would have been a crisis the U.S. government could not solve, for you can't calm a flight from the dollar by printing more dollars. But subprime mortgages? Too small to have an impact on a global economy with $80 trillion of financial assets, we said.

Strategic intervention to rebalance financial markets works--until and unless the government's liabilities mount to a level that cracks the government's credibility as an issuer of safe and liquid assets. But we are not there yet. And even though we are not there yet the Treasury, the Federal Reserve, even the White House, and working majorities in Congress appear... happy... with the fact that nominal GDP is still 8% below its pre-2008 trend and promises to stay there for as far into the future as I can see.

I was wrong.

But I don't think I was wrong because the government does not possess the power. I think I was wrong because the government does not possess the political will to do what ought to be done and the technocratic clarity of thought to understand what strategic interventions in financial markets are likely to work and what ones are likely to simply be wastes of money.

Third, I thought that economists had an effective consensus on macroeconomic policy that did indeed stretch back to the days of Walter Bagehot and John Stuart Mill: that the task of the government was to intervene strategically in asset markets to stabilize the economy. I thought that all of the disputes within economics were over what was the best way to accomplish this goal: monetarists who believed the key was the stock of liquid assets vs. Minskyites who believed the key was the stock of safe assets vs. Hicksians who believed the key was the stock of long-duration assets to serve as savings vehicles. But it always seemed to me that Friedman and Tobin--and Keynes, Fisher, Wicksell, Bagehot, etc.--were not just on the same continent but were in neighboring villages. And when things got bad and we hit the zero lower bound on nominal interest rates the academic economics profession would call with one voice for more and bigger strategic interventions in financial markets to boost nominal GDP back to its trend.

I was wrong.

Whether it is Ed Prescott claiming that the Great Depression was the result of the policies of that communist Herbert Hoover, Eugene Fama claiming we live in a cash-in-advance economy with a technological limit on velocity, Robert Lucas claiming he does not understand why a government would ever want to lend freely to overleveraged financial institutions, Richard Posner and Robert Lucas claiming that Christie Romer and Larry Summers are lying when they say that they think fiscal expansion might be effective and is worth trying--the technocratic expertise at stabilization policy that we have turns out to be not part of economists' consensus framework but instead to be sufficiently contested at every level as to have had remarkably little impact on actual policy.

Phil Swagel was in the belly of the beast--during those days when we realized that Wall Street risk controls were so bad subprime could cause s big problem, during those days after the collapse of Bear Stearns when it looked as though the Federal Reserve had guaranteed the unsecured liabilities of every commercial and investment bank and thus unleashed a liquidity tsunami that would make inflation our biggest problem, and during the collapse.

My cries that we ought to have done better... Marcus Tullius Cicero once complained that Marcus Porcius Cato insisted on thinking that he lived in the Republic of Plato when he actually lived in the Sewer of Romulus. Phil Swagel is next to explain, among other things, that I am making Cicero's mistake.

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