Ideas over Interests

Dani Rodrik on the economists’ role in bringing about the most recent financial crisis:

In the aftermath of the financial crisis, it became fashionable for economists to decry the power of big banks. It is because politicians are in the pockets of financial interests, they said, that the regulatory environment allowed those interests to reap huge rewards at great social expense. But this argument conveniently overlooks the legitimizing role played by economists themselves. It was economists and their ideas that made it respectable for policymakers and regulators to believe that what is good for Wall Street is good for Main Street.

Economists love theories that place organized special interests at the root of all political evil. In the real world, they cannot wriggle so easily out of responsibility for the bad ideas that they have so often spawned. With influence must come accountability.

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Not a Polemic: Galbraith on Inequality

When I picked up Jamie Galbraith’s new book, “Inequality and Instability,” (OUP) I was expecting something pretty simple: a pithy narrative of how inequality in the 2000s destabilized the world economy by forcing demand to grow through a credit bubble. However, Galbraith did waited until the very end to cover that argument. Instead, he spent the majority of the book using inequality as a lens to recast our economic history from the last several decades.

For those seeking a Krugman-esque polemic that weaves together narrative threads on how the crisis happened (as I was), this book may be disappointing. It offers a rich set of essays on inequality that draw from careful work of applied statistics. Galbraith develops a novel approach to dealing with income and wage data for inequality statistics, and then hops around the globe, retelling the stories of regions and countries alike in light of data on inequality. By sector, region, and year, Galbraith shows how countries from Cuba to Argentina to Norway have changed over time.

His data yields rich insights; for example, based on a careful study of US data, he concludes,

There are practically no jobs to be had in the winning sectors…the American economy became leveraged, in such a way that its performance as a whole came to depend on the possibility of a very small number of people becoming very rich in very limited lines of work.

Piketty and Saez have offered data that shows the fractal-like qualities of the entire income distribution, but Galbraith’s data, by sector and region, show that economic geography matters deeply.

Later, writing about Argentina and Brazil, Galbraith finds that

declining inequality in this part of Latin America appears directly linked to a weakening of the political forces that supported neoliberal globalization.

Galbraith’s sector-level view of the economy leads to some key conclusions about finance as well- he finds that finance drives inequality, and as it siphons more and more of total income, its cycles drive employment as well. With these insights in hand, Galbraith does eventually get around to the argument I was waiting for:

The financial crisis…was the consequence of a deliberate effort to sustain a model of economic growth based on inequality that had, in the year 2000, already ended….when the collapse came, it would utterly destroy the financial sector.

Of course, finance’s role in the economy persists heavily, and economists and politicians alike continue to debate its value. What is clear from Galbraith’s work, though, is that growth based on finance will likely not be shared, and thus, not sustained.

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Pity the Billionaire

Thomas Frank hits the nail on the head when describing responses to the crisis in his new book, Pity the Billionaire. First, there is the Tea Party response, which views the problem as government intervention, despite strong evidence that deregulation of financial markets and institutions is the greater culprit. Thomas Frank writes that this response was “as extraordinary as if the public had demanded dozens of new nuclear power plants in the days after the Three Mile Island disaster”:

Before the present economic slump, I had never heard of a recession’s victims developing a wholesale taste for neoclassical economics or a spontaneous hostility to the works of Franklin Roosevelt. Before this recession, people who had been cheated by bankers almost never took that occasion to demand that bankers be freed from red tape and the scrutiny of the law. Before 2009, the man in the bread line did not ordinarily weep for the man lounging on his yacht.

This naturally raises the question, what has been the response from the other side? The point that I have made before, and Frank makes in this book, is that the response from the other side has been “nothing”:

On the surface, the Tea Party line and the new revived radicalized conservatism sounds pretty good. They’re asking questions that need to be answered. Why did the regulators fail? I mean, that’s a really good question. Their theory is that, you know, it’s government. Government always fails. Right?

The important thing is what’s the answer coming from the other side? What is, say, the administration of Barack Obama? What’s their answer to the question? You know what it is? Nothing. They don’t ever talk about it.

This is the key point. The Left has not had a response to the crisis. And in my opinion, the key obstacle is that the Left does not have a theory about the crisis. This is the main difficulty that the Occupy Movement faces. And neoclassical economics has not been much use. Neoclassical economics has an obsession with general equilibrium; price changes occur when there is a shock to either demand or supply, but a new equilibrium should quickly take hold. It’s not clear that this story is at all useful: there was no external shock, rather the financial markets proved to be inherently unstable. It’s even hard to see how the concept of equilibrium is useful in our present situation.

Going forward, this is the paramount challenge to liberal economists. We need to build a new theory, one that answers these questions that so many people ask but mainstream economists cannot answer: why did the regulators fail? How can we think of markets as inherently unstable? And, as Thomas Frank warns, we want to make sure that this new theory does not pity the billionaire, as does the Tea Party response.

 

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Bank Transfer Day

The Occupy Wall Street movement has spurred forward various other movements that attempt to imagine a new, people-based economy. One such initiative was Bank Transfer Day [ht:cr]:

Bank Transfer Day began out of the Occupy Wall Street movement as thousands of Americans took to rallying in Lower Manhattan against, among other things, the bailout of the institutions that have made many homeless and broke. As the Occupy movement spread from city to city, so did the agenda of the demonstrators. Bank Transfer Day quickly became a hot topic across the Internet and in Occupy encampments across the country, and with the help of the hacking collective Anonymous, snowballed into a major part of the large Occupy agenda.

“The 99 percent movement is all about finding ways for people to change the economy that is benefiting only the 1 percent,” Courtney Yax, 24, tells The Buffalo News. “Bank Transfer Day is about the power of individuals to take their money out of institutions whose profits go almost entirely to Wall Street and keep that money in our community, where we can control it.”

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‘Wicked Smart’ and on her way out

Despite the loud calls for Obama to appoint Elizabeth Warren to head the Consumer Financial Protection Bureau, she is now unfortunately on her way out. This is a huge loss for middle class Americans and another victory for Wall Street. Warren was the ideal leader of the CFPB, an concept which she helped inspire. There has been considerable evidence over the past few years that (1) Financial markets are inherently unstable in a Minskian sense and that (2) the regulated (financiers) are in a never ending race with the regulators; the CFPB was a truly creative and dynamic strategy with a real potential to protect Americans from economic volatility and financial frenzy.

I do hope that the CFPB is still able to fulfill its role, and indeed it still has the potential to be effective. But I remain convinced that it would have been most likely to have a real impact on our society with Elizabeth Warren behind the wheel. Passing her up was a mistake on Obama’s part.

Update: from David Corn which both sounds reasonable and makes me feel better:

The Sunday afternoon news that the White House would not be nominating Elizabeth Warren to head the Consumer Finance Protection Bureau (CFPB) certainly has the potential to trigger outrage from progressives who believe President Barack Obama too often declines to confront Republican extremism. Warren, the populist Harvard professor who birthed the idea for a government agency that would protect consumers from tricks and traps perpetrated by banks, mortgage firms, and credit card companies, was the right person for the job. So much so that congressional Republicans have been howling about the prospect of her leading the agency even before the bureau was created last year by the Wall Street reform legislation. Which is why Obama’s decision not to fight for her—and it would have been a titanic fight—may disappoint. But there’s an upside to the move: the possibility that Warren will end up in the US Senate. And there’s this: The fellow Obama picked for the position, Richard Cordray, can be expected to do a fine job pursuing abusive financial firms.

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“The Riddle of Money, Finally Solved”

Below is a guest post from Philip George, whose website is philipji.com. The post is a shortened version of a longer article you can find on his website here. Some related posts are here and here.

For nearly a century the progress of macroeconomics has been stalled by a single error, the error of regarding money as cash balances and the demand for money as the demand for cash balances. It is an error that is common to the Keynesians, the monetarists and the Austrians. And it has been taught to every economics undergraduate for generations so that it is etched into the collective consciousness of all economists.

To view it in practice look at how Milton Friedman used it. For Friedman money is an asset, one of many alternative assets, such as stocks, bonds, durable consumer goods, or even human capital. To determine the demand for money one has to compare it with the demand for those alternative assets. If Paul wishes to hold more stocks and bonds it follows that his demand for money and therefore his cash balances will come down.

So where is the error? Consider that Paul decides to hold fewer bonds than he did, preferring instead to hold more money. In Friedman’s analysis his demand for money has gone up. But the only way that Paul can reduce his holding of bonds is to sell some to Peter. So Peter’s holding of bonds goes up and his demand for money goes down. Although Peter and Paul can change their individual stocks of bonds and money, their combined stock of bonds or combined stock of money cannot change. By trading in financial assets the stock of money in the economy cannot be changed one whit.

In Friedman’s model of the economy money exists only in the form of currency. There are no banks and the only way in which money can be increased or decreased is through the agency of the central bank. To see how such a model results in errors for Austrians, see http://www.philipji.com/stupidity-of-economists.html, and for how it lands Keynesians in errors see http://www.philipji.com/paul-krugman-and-the-liquidity-trap.html.

So what is money? To answer that question, we begin with the money multiplier. In its simplest form, this is how it works. The central bank buys $100 worth of, say, government bonds, from a bond dealer. The dealer deposits the $100 in a commercial bank. Assuming that the reserve ratio is 20%, the bank has to retain $20 as a reserve; so it lends out $80. Assuming this is deposited in another bank, the second bank now has to retain 20% of this $80 as a reserve i.e. $16 and can lend out $64, which in turn is deposited in a third bank. By adding up the entire chain of new deposits it can be shown that the $100 created by the central bank’s initial purchase of a bond for $100 will result in the creation of $500 of new money.

We show the process in a simple diagram as below, where M is the reserve, m is the multiplier, and mM is the money created.

The money multiplier

So far, Keynesians, monetarists and Austrians will all be in agreement with us. Curiously none of them seems ever to have asked: What happens when this newly created money mM is spent? We now ask the question by drawing the figure below.

The money multiplier integrated with the economy

And having asked the question we are immediately confronted by a problem. At A the central bank injects M dollars into the system. The banking system, through a series of loans and deposits, converts it into mM dollars at B. When this money returns to A, it is then converted by means of the multiplier to a value of m²M at B. In the next cycle this becomes m³M at B, and on on in an ever-increasing spiral. Equilibrium, it would seem, is impossible.

There is only one way out. For equilibrium to be maintained the money created while moving from A to B must be destroyed in the movement from B to A. We answer one objection immediately. Why isn’t the entire mM dollars created at B spent? That is to say, why is M dollars retained unspent at A while moving from B to A? The answer is quite simple: in the money multiplication process described at the start of this section, when 500 dollars of new money is created, 100 dollars has to be retained by all the banks together as reserve.

The answer to the second question may be a little more difficult to appreciate. How is the amount of money mM at B destroyed so that it becomes M at A? The answer is that the destruction happens through the mechanism of saving. Each person who receives money spends some of it while saving a little and withdrawing it from the system. The total of this saving must be exactly equal to the net money created mM-M for equilibrium to be maintained. But people do not hide their savings under their mattresses. Because they are assured that the central bank will not allow the disorderly failure of banks they place their savings in the bank. We draw the result as in Fig 3 below.

Savings and money creation in the economy

Simple though it is, this is the model of the economy that has eluded economists so far. In it a) Money is created when banks lend money and is destroyed when loans are liquidated and b) Money is endogenous i.e. it can be created and destroyed without the intervention of the central bank.

Many conclusions can be derived from this model. For instance,

a)     If the injection of money  into the system by the central bank is multiplied by a process of bank lending, it can be sustained only if the system produces an equivalent amount of saving and this saving is loaned out again.

b)    It is possible for the system to remain in equilibrium when the economy is operating at levels far below full employment.

c)     It is possible to estimate the amount of money (an aggregate I call Corrected Money Supply) by estimating the amount of savings in demand deposits and by subtracting this amount from M1. See http://www.philipji.com/riddle-of-money/ For the period from 2001 to 2011 we get a graph accurately tracks the economy.

 

Corrected Money Supply 2001 to 2011

 

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Hyman P. Minsky Summer Seminar

The Levy Economics Institute of Bard College is pleased to announce that it will hold the second annual Minsky Summer Seminar June 18–26, 2011. The Seminar will provide a rigorous discussion of both the theoretical and applied aspects of Minsky’s economics, with an examination of meaningful prescriptive policies relevant to the current economic and financial crisis.

This summer seminar at the Levy Institute is probably one of the most important economics seminars that will take place this year. Minsky’s theories, which are completely absent from any top, mainstream economics graduate program, explain the inherent instability of financial markets as part of the normal cycle of the economy. During prosperous times, speculative euphoria leads to an endogenous credit bubble. This credit fueled euphoria is of course unstable, an eventually leads to panic and financial crisis.

The tools used in mainstream macroeconomics completely rule out any possibility of asking these types of questions. Dynamic optimization done by a representative household and a representative firm limits macroeconomics to consider the “stable equilibrium” of the economy, and the only questions that can be asked concern what happens when there are slight deviations from that stable point. The answer, of course, is that the market forces and arbitrary opportunities push the economy back to the stable point.

Economic historian Charles P. Kindleberger was likely the foremost authority on economic bubbles. In Manias, Panics, and Crashes: A History of Financial Crises (2005) Kindleberger surveyed major financial crashes and used the Minsky model to understand their evolution. Had this work been taken seriously when it was published in 2005, we would almost certainly have been better prepared to deal with the subprime mortgage crisis. But instead, it took the largest  economic crisis since the Great Depression to bring renewed interest to Minsky’s model. Hopefully, the Levy Institute will continue to help us make sense of this extremely important phenomenon that the mainstream has neglected.

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“Why Isn’t Wall Street in Jail?”

These are just some great paragraphs from Matt Taibbi, and I should’ve posted them several weeks ago:

So there you have it. Illegal immigrants: 393,000. Lying moms: one. Bankers: zero. The math makes sense only because the politics are so obvious. You want to win elections, you bang on the jailable class. You build prisons and fill them with people for selling dime bags and stealing CD players. But for stealing a billion dollars? For fraud that puts a million people into foreclosure? Pass. It’s not a crime. Prison is too harsh. Get them to say they’re sorry, and move on. Oh, wait — let’s not even make them say they’re sorry. That’s too mean; let’s just give them a piece of paper with a government stamp on it, officially clearing them of the need to apologize, and make them pay a fine instead. But don’t make them pay it out of their own pockets, and don’t ask them to give back the money they stole. In fact, let them profit from their collective crimes, to the tune of a record $135 billion in pay and benefits last year. What’s next? Taxpayer-funded massages for every Wall Street executive guilty of fraud?

The mental stumbling block, for most Americans, is that financial crimes don’t feel real; you don’t see the culprits waving guns in liquor stores or dragging coeds into bushes. But these frauds are worse than common robberies. They’re crimes of intellectual choice, made by people who are already rich and who have every conceivable social advantage, acting on a simple, cynical calculation: Let’s steal whatever we can, then dare the victims to find the juice to reclaim their money through a captive bureaucracy. They’re attacking the very definition of property — which, after all, depends in part on a legal system that defends everyone’s claims of ownership equally. When that definition becomes tenuous or conditional — when the state simply gives up on the notion of justice — this whole American Dream thing recedes even further from reality.

 

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Dollars and Depressions

In the last two weeks, I read two books that sit firmly in the world of finance and money. The first is Barry Eichengreen’s Exorbitant Privilege, from Oxford UP, and the second is Liaquat Ahamed’s Lords of Finance, which has won a number of awards including the Pulitzer Prize. Ahamed’s book reads almost like a novel, with a diverse cast of characters found in the key central bankers of the era. His book is ultimately one of technocratic bumbling in the context of a political vacuum, wherein the key countries, often for reasons of domestic pride, hold hostage sound economic policy. By far the most interesting vignette comes early on, with regards to the issue of Germany’s World War I reparations. Ultimately, all sides end up compromising, but it’s not enough to prevent Germany from heading into a spiral ahead of the rest of the world (and eventually into fascism). While long, Lords of Finance is extremely entertaining.

One wants to continually draw parallels with the recent crisis. Of course, the central bankers of the times had a living and breathing Keynes, whose work is well woven into the story. Nevertheless, Keynes was probably too new at the time to have a meaningful impact. And of course, in the lead up to our crisis, Keynes was willfully ignored, and has had a minor resurgence among policymakers. Bernanke, Paulson, Brown, et al. look like financial wizards in comparison to Norman, Strong, Schacht, and Moreau. Nevertheless, given the greater global political consensus on the need for action, it is somewhat disappointing that the solutions were still half-measures, and the banks have only gained more power over governments, finance ministries, et al. This book shows we’ve come a long way, but still have far to go.

Eichengreen also has a keen knowledge of history- he traces the rise of the dollar through history, showing the economic and political underpinnings of it’s dominance and the sterling’s faltering. His book is most interesting when it discusses the role of the dollar in the present day, and the shortcomings of possible usurpers. What Eichengreen deserves most praise for is his discussion of the ability for a multipolar currency world to arise amid a multipolar global economy. Though he shows how the dollar’s dominance was indeed an “exorbitant privilege” for the US economy, it is clear that economic strength leads to currency dominance, not vice-versa. However, even amid our stagnation, Eichengreen rightfully cautions against assuming that the dollar will fall. Parts of the book could be summed up as, “rumors of the dollars demise are much exaggerated.”

Money is an area I don’t understand sufficiently, but this book helped me understand what brings about a strong or weak currency. However, I was annoyed at the last chapter, which attempts to argue that US deficits will ultimately determine the US’s ability to dominate. The evidence for this is never given- rather, it’s merely assumed that a large federal debt need imply stagnation. Most economists will go along with this, so I suppose it’s fine that he does. However, I don’t think the connection between the deficit and the dollar is intellectually strong. Indeed, the dollar has been a haven for investors amid economic uncertainty and record deficits. The dollar may not dominate forever, but perhaps its fall could come from too little deficit spending and thus too weak an economy. I agree with one of Eichengreen’s closing sentences, “the fundamental underlying health the economy matters for geopolitical leverage. If one wants a single unified explanation for the behavior of the exchange rate…it would be [that].” Indeed, but perhaps we need a better macroeconomics to probe that underlying health.

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“Inequality, Leverage, and Crises”

Commenter Tomboktu tipped me to an IMF working paper from last month by Michael Kumhof and Romain Ranciere, “Inequality, Leverage, and Crises.” I referenced it in my previous post about plutonomy. In this paper, the authors use conventional tools like a DSGE model to explain the curious fact that,

Both [the Depression and current recession] were preceded by a sharp increase in income and wealth inequality, and by a similarly sharp increase in debt-to-income ratios among lower- and middle-income households. When those debt-to-income ratios started to be perceived as unsustainable, it became a trigger for the crisis.

How? Their mechanism actually flows through financial channels, rather than through slacking aggregate demand, which I’ve mainly promoted as the key driver on this blog; however, the two explanations need not be exclusive. The main insight derived from their model is that,

Prior to the crisis, increased saving at the top and increased borrowing at the bottom results in consumption inequality increasing significantly less than income inequality. Saving and borrowing patterns of both groups create an increased need for financial services and intermediation. As a consequence the size of the financial sector, as measured by the ratio of banks’ liabilities to GDP, increases. The crisis is characterized by large-scale household debt defaults and an abrupt output contraction as in the 2007 U.S. financial crisis.

As their title indicates, they also describe this process in leverage terms in the conclusion:

The key mechanism, reflected in a rapid growth in the size of the financial sector, is the recycling of part of the additional income gained by high income households back to the rest of the population by way of loans, thereby allowing the latter to sustain consumption levels, at least for a while. But without the prospect of a recovery in the incomes of poor and middle income households over a reasonable time horizon, the inevitable result is that loans keep growing, and therefore so does leverage and the probability of a major crisis that, in the real world, typically also has severe implications for the real economy.

I also enjoyed the paper because of bits like this:

And as far as strengthening the bargaining powers to workers is concerned, the difficulties of doing so have to be weighed against the potentially disastrous consequences of further deep financial and real crises if current trends continue.

The takeaway for policymakers is that,

More importantly, unless loan defaults in a crisis are extremely large by historical standards, and unless the accompanying real contraction is very small, the effect on leverage and therefore on the probability of a further crisis is quite limited. By contrast, restoration of poor and middle income households’ bargaining power can be very effective, leading to the prospect of a sustained reduction in leverage that should reduce the probability of a further crisis.

I shouldn’t be so surprised that a relatively heterodox conclusion is coming from the IMF, which last year produced a working paper rethinking capital controls. The crisis is undoubtedly causing some serious rethinking in some scholarly circles. Even if this paper is using relatively conventional tools, it is asking an unconventional question is the mainstream. The key question for the economics discipline is whether papers like this, which ask the right questions, will receive the attention (and scrutiny) that they warrant.

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