The last Economic Crisis, in 2007, was more intense, widespread, and brought in a far longer lasting wave of destruction than Hurricane Katerina, which had decimated New Orleans barely two years earlier. Seen as a temporary ` blip in the credit markets….’, a ‘mere hiccup in liquidity and not solvency ’, not more than a handful of economists expected the effects to spread from the financial sector to the real sector of the economy.
The tribe was quick to point out how the crisis on Wall Street caused by the collapse of the super hedge fund ‘Long Term Capital Management (LTCM)’ in 1997,was dowsed by swift action by the Federal Bank of New York. On that occasion, Timothy Geithner, the then Governor of the NY Feds arm twisted a consortium of Wall Street brokerage firms and Banks to inject liquidity into the system to contain interbank overnight credit flows from drying up. The real economy hardly felt the ripples of what was, essentially, a Wall
Street matter. Even the ‘Black Monday’ of 1987, had hardly roiled the business cycle. What the bankers forgot was that the LTCM misadventure was sui generis, a new-kid-on-the-block getting its comeuppance for being too clever by half and going by the advice of nerdy Nobel laureates3.The macroeconomists were even more effete. ”The problems of Wall Street will never enter Main Street” they cried in chorus. The Central Bankers loftily agreed. Events unfolded rapidly. Within a month of Bears Sterns collapsing, it was increasingly clear to most that Lehman Brothers, Merrill Lynch, Morgan Stanley and yes, Citigroup and Goldman Sachs would topple over like dominoes. And yes, this time around, banks faced a fundamental problem of solvency and not liquidity. And yes, this time around, the real sector would be affected: already, a recession was threatening to blow up into a full-fledged depression. The levees had been breached. My intention is not to write a rehash. There is no dearth of excellent books that have come up since.
What is the most frightening, yet fascinating thing about Macroeconomics is that the moment you think that you know what causes fluctuations in the economy, and how to dampen the same, fate lands you a solid blow to the solar plexus that puts you out for the count. It has happened three times within the last hundred years, starting with the Great Depression of 1929, and twice since I cut my milk teeth in the early 70’s learning Economics from the 8th Edition of Paul Samuelson’s classic textbook. That textbook, if I remember right, had a Chapter attributed to Milton Friedman that said, “We are all Keynesians now”5. No sooner had we grappled with, and understood the Keynesian multiplier, the Hicksian IS-LM curves, and the Phillips model showing the inverse relationship between inflation and unemployment, that tragedy struck out. The twin OPEC oil shocks of 1973 and 1974, brought in its wake an ogre that we couldn’t even identify. It was called ‘Stagflation’ – a combination of recession and chronic unemployment accompanied by high inflation. All known policies, mostly fiscal, in the standard Keynesian tool-box could not explain this phenomenon, far less suggest policies to ameliorate the situation. The Keynesians were in retreat. In 1979, Robert Lucas and Tom Sargent came out with their powerful new manifesto for New Classical Economics “After Keynesian Macroeconomics”
The New Classical synthesis was elegant, and based on firm microeconomic-foundations, and mathematically rigorous. It could explain a lot more about the ‘stylized facts’ about business cycles. In its simplest avatar it brought in the notion that aggregate demand was not the only determinant of what determined full employment, or equilibrium, as most Keynesians believed. There was also the factor of aggregate supply which was based on ‘endogenous’ factors like labour productivity, technological shocks (such as the effects of the OPEC oil price rise) and that fluctuations in output and employment were caused not only by aggregate demand movements but also shocks in aggregate supply. 6
Side by side came the notion that economic agents all act with ‘rational expectations’. 7 This was a departure from Friedman, who believed that agents’ behaviour could be explained through ‘adaptive expectations’. What Friedman meant was that in any multi-period span, economic agents would set their expectations for tomorrow on what happened today. In contrast, the Rational Expectation school believed that adaptive expectations had a bias for the persistence of error over time. In its simplest form, consider a farmer who experiences a crop failure due to poor rainfall today. He sees the prices of the curtailed wheat production go sky high. What does he do the next season? An agent following adaptive expectations would plant more than he should –and if all other farmers follow suit- we could expect a glut in wheat production and a crash in wheat prices next year. Under rational expectations, an agent would realize that high prices today is an aberration and base his output decisions on, perhaps, some average of prices over the last five years. Mind you, rational expectations do not imply perfect foresight. Errors would still arise, but these errors would be uncorrelated (referred to as ‘White Noise’ errors). Agents’ actions will be consistent with some rule or model.
By the second half of the 80’s, the New Classical school was joined by the Real Business Cycle School8. Both these approaches are characterized by the market clearing in perfectly competitive scenarios. Both theories had a common strand: Government intervention of the Keynesian type, specifically fiscal policy to counter cycles, were of no consequence. While the New Classicalists saw a role still for monetary policy, the proponents of the Real Business Cycle School saw shocks as essentially from the supply side, caused by technological shocks, and affecting the trend-line of the long term cycle. Here, monetary policy too had a limited role.
This, then, was the theoretical orthodoxy that ruled much of Macroeconomic thinking from the 80’s till the crisis struck. The new theory was an essential ingredient of a wider political economic move towards Neo-Liberalism championed by Mrs. Thatcher in the UK and Ronald Reagan in the USA. It ushered in an era of free markets unseen since the days of Adam Smith. Privatization of public sector enterprises, deregulation of markets, and a retreat of the State from many economic activities, were the hallmarks of the early years. Many of the policies made sound economic sense. The State, since the end of the Second World War, had indeed encroached into areas where it had no domain knowledge. Trade Unions had brought Nations like the UK on its knees. Newly independent countries had unwisely adopted either Marxist forms of Government or Fabian Socialism, which put their growth and development back by decades. Side by side, however, the new economic liberalism also brought in its wake ideas that bordered on the lunatic fringe, like The Laffer curve on taxation. Internationally, USA pushed a corpus of policies known widely as the Washington Consensus on emerging market economies through the agencies of the World Bank and the IMF. The collapse of the erstwhile Iron Curtain was a further vindication of this philosophy.
The Keynesians of yesteryear accepted many of the precepts of the New Classical school. Rational Expectations, the idea of an Aggregate Supply function and microeconomic foundations were quickly assimilated. What the Keynesians found difficult to accept, however, was instantaneous market clearing, especially in the labour markets. The condition of Europe, where chronic unemployment continued to persist for years, proved a clear counterfactual to the New Classical story. To explain these phenomena, and ‘sticky prices’, the New Keynesians brought in ideas of Imperfect Competition, Asymmetric Information, Implicit Labour Market contracts, Menu costs and such ‘grit’, which explain delays in market adjustment and clearance in the face of shocks 9.
The new Macroeconomics brought in its wake much sophistication in modelling the economy and specifically in the econometric analysis of time-series data. Recognizing that causation was not clear between different economic variables, new ideas such as Co-Integration of Variables10 (where we measure the degree of association between, say, employment and prices) modified the conventional regression analysis. By the late 1990s, these models got distilled into the workhorse of modern Macroeconomic analysis, the Dynamic Stochastic General Equilibrium (DSGE) models.
While a discussion and critique of the DSGE models is a separate subject in itself, it will suffice to say that they are ‘Dynamic’ insofar as they look at the economy over a period of time, and not at a single point; ‘Stochastic’ refers to the fact that they can deal with random shocks like an oil or technology shock, to the extent that such shocks can be anticipated and a clear probability assigned to its occurrence ( which almost invariably never is), and the General Equilibrium portion relates to the assumption that all agents are similar, and thus, if a single agent is in equilibrium, the whole system would also be. These were pretty strong conditions, quite different from Walrasian theory or Arrow-Debreu’s notion of General Equilibrium. By and large, the New Keynesians rejected it while the New Classical and Real Business Cycle acolytes embraced the methodology because it validated most of their claims. The doyen of Growth Economics, Robert Solow, pithily commented that “the DSGEs do not even pass the smell test”10.
Strangely enough, the New-Keynesian School has congregated in most Universities along the East and West Coast, while the New Classical and RBC followers are mainly domiciled in schools around the Great Lakes such as Chicago, Minneapolis and Ann Arbor, Michigan. The division is thus clearly between ‘Saltwater’ economists and ‘Freshwater’ economists.
The 2007 Crisis was ‘unexpected’. Twenty years of benign cycles had brought in the term,’ the period of Great Moderation’. Alan Greenspan ruled over the Fed till 2006. He believed that the beast of economic cycles had been tamed. He also refused to look into the seriously overleveraged balance sheets of banks and financial institutions with esoteric derivative products like Collateralized Debt Obligations (CDOs) and Asset Backed Securities, based on dodgy housing mortgages. His successor, Ben Bernanke, an authority on the 1929 Great Depression, also asserted on assuming Office that “the economy was never in better shape”.
Once the Crisis hit, Bernanke found out quickly enough that monetary policies had their limits. As interest rates quickly approached zero, this was no surprise. What we had was a full blown depression with a classic Keynesian liquidity trap. Only the maverick Princeton enfant terrible of Economics Paul Krugman had guessed right. In fact, the economic collapse of Japan in the mid-1990s had provided a chilling foretaste of things to come. Krugman had made that call, correctly too.11
We have come 8 years since the crisis struck. The USA is well on its path to recovery, owing to a flexible mix of policies, some misguided, others apt, followed by the Treasury and a pragmatic Ben Bernanke. Europe is still in the dumps, a clear victim of the contradictions of having a pure Monetary Union. The Chinese ‘bluff’ stands exposed. India still lives in a land of make- believe that it is an economic superpower which boasts of 8 percent plus growth rates, much to the amusement of many, thumping its reported 56-inch chest much like a loincloth clad Tarzan on 5th Avenue.
The big question is: Do we have a theory that can explain when, where or how the next crisis will be coming from? The answer is NO. We know of some of the missing pieces from the earlier jigsaw puzzle. The financial sector is easy to recognize. We are still very far from predicting what constitutes a bubble in the financial sector, and how exactly to integrate the sector into the Real economy. That is a story I’ll leave for tomorrow.
Boz is the nom de plume of a retired Civil Servant with experience in the Finance Ministry and the International Monetary Fund.
 Bibliography and References:
- Bob Dylan-‘Ballad of a Thin Man: from the album – Highway 61 Revisited.
- Nouriel Roubini, of the Stern School of Management at Columbia, was one of the few who had warned about a housing led crisis since 2002. Raghuram Rajan, in 2005, sounded out warnings at the Jackson Holes conclave.
3.”When Genius Failed”; by Roger Lowenstein gives an excellent exposition of the rise and fall of LTCM, founded by John Meriwether, with Robert Merton and Myron Scholes as Advisors. Scholes and Fischer Black got a Nobel for the Black –Scholes option pricing model.
- “Too Big to Fail” –by Andrew Ross Sorokin is an excellent exposition. Books by Michael Lewis, Gillian Tett, give good expositions of what happened in the financial sector. Nouriel Roubini, George Akerlof, Robert Schiller, and Alan S. Blinder have written more on wider economic aspects
- The quotation is from the Time Magazine (1965). Milton Friedman says he was misquoted. What he averred he did say was, “In one sense we are all Keynesians now; in another, nobody is a Keynesian”.
6 and 7: Robert Lucas(1972) ”Expectations and the Neutrality of Money” (JET-1972) and Robert Lucas (1976) “Econometric Policy Evaluation: A Critique”– Lucas took the Rational Expectations framework developed by John Muth in 1961, applied it to Friedman and Phelps’s view of the long run neutrality of money, and provided an explanation of the correlation between output and inflation.
- “Real Business Cycles” were based on papers by Edwin Prescott and Finn Kydland. They see business cycles driven entirely by exogenous technological factors and explicitly reject Keynesian theories of policy effectiveness.
- Nobuhiro Kiyotaki and Olivier Blanchard developed the theory of Monopolistic Competition and the effects on Aggregate Demand, Gregory Mankiw mooted the Menu Cost idea, and Stanley Fischer developed the first model with sticky prices. Implicit contracts were modelled by Gordon and Azariades.
- The Real Business Cycle school’s Kydland and Prescott were the founding fathers of the DSGE models. Some of the New Keynesians too have embraced the DSGE, for example Smets’ and Wouters’ 2007 model. Solow’s written statement was delivered before the House Sub Committee of Congress enquiring into reasons which led up to the crisis.
- Paul Krugman –“ The Return of Depression Economics” (2000)
Boz is the nom de plume of a former civil servant with many years of experience in the Ministry of Finance, financial institutions, and the IMF at Washington.