Red Alert

The Naked Economist: Part 1

Posted by on June 29th, 2010

There has been a quiet revolution underway in economics in the wake of the global financial crisis.  The “Washington Consensus” is no longer a consensus.  The “Great Moderation” has become a Memphis meltdown.

 As in most revolutions, pressure begins gradually.  Someone then states what is already obvious to all: the “Emperor has no clothes”.  Suddenly, orthodoxy crumbles.  As shown by the recent Toronto G20 summit, in 2010 orthodox economics stands suddenly naked. 

 The foundations have been shaking for a while.  Assumptions of “rationality” have taken a hit from “behavioural economics”.  Stock markets over-react due to fear and greed.  Trickle down trickles up.  Asset bubbles inflate then burst, as in 2008.

For me the “no clothes” moment for macroeconomics happened in February this year.  The Chief Economist of the International Monetary Fund (IMF), Olivier Blanchard, released a ‘position note’ entitled “Rethinking Macroeconomic Policy”. 

Early local media pickup focused on monetary policy, noting Labour’s recently announced withdrawal from the previous monetary consensus.  This has been comprehensively confirmed in two speeches last week by Phil Goff and David Parker.

Blanchard’s critique of “What We Thought We Knew” is, however, much broader than earlier local reaction:

  •  Monetary policy had one target, inflation, and one tool, the policy rate (our ‘official cash rate’ (OCR)).  With low, stable inflation the ‘output gap’ (unemployment) would be small and monetary policy would always do its job: spot the Tui billboard moment.
  • Fiscal policy (government spending and taxing) was secondary at best: hopelessly slow, un-necessary if monetary policy was sound, and subject to nefarious political influence. 
  • Some financial regulation was ok but financial intermediation (leverage, derivatives and stuff) didn’t matter much in terms of managing the broader economy. 

Welcome to the Washington Consensus:  “By the mid-2000s, it was not unreasonable to think that better macroeconomic policy could deliver, and indeed had delivered, higher economic stability.  Then the crisis came”.

Recounting “what we have learned”, Blanchard nails with laser-like clarity six home truths for our uncertain new world.

  •  Stable inflation may be necessary but is not sufficient. Housing bubbles, current account deficits and consumptions binges are serious problems.
  • Low inflation limits the scope of monetary policy in a severe recession.  There may not be room to cut policy interest rates far enough to avoid deflation.
  • Financial intermediation matters.  When financial markets are segmented and arbitrage (interest rate pass-through) breaks down, the OCR no longer works as a policy tool.  Our 2009 Parliamentary Banking Inquiry found just that.
  • Counter-cyclical fiscal policy is an important tool.  Take a bow Michael Cullen, who cut Crown debt by saving surpluses then timed perfectly the recession-fighting 2008 Budget.  That gave NZ a buffer to limit the 2008-09 slump.
  • Regulation is not macro-economically neutral. Weaknesses in US financial regulation amplified a local property crash into a global crisis.  More generally, deregulation is no cure-all (not welcome news in the current Beehive).
  • The “Great Moderation” looked good for so long because it coped with small imbalances and had not faced the full consequences of understated systemic risk, especially around financial leverage and exchange rate exposure.

So what does this all mean for the next generation of policy makers?  The next era should retain the best of the previous consensus, while creatively addressing the challenges that previously lay outside it.    

Part 2 of this post will follow shortly.   Comment is welcome on Blanchard’s critique.


24 Responses to “The Naked Economist: Part 1”

  1. Wilbur says:

    And yet labour supported free trade with Malaysia, opening our economy further up to the turbulencies that plague the qorld economy?

  2. Loota says:

    Wilbur – how do you know that we have a trade deficit with Malaysia? We may be having solid benefits from the relationship :)

  3. Loota says:

    Also – it was in certain parties’ commercial interests to drive hot money into speculative consumer bubbles while at the same time reducing or negating both Govt and internal oversight/regulation in order to maximise the leverage that they could apply. 30:1 or 35:1 leverage became common place, while basic banks and other financial institutions suddenly grew in reach and then into huge unwieldy unproductive (some would say parasitic) parts of the economy.

    The word “sustainable” doesn’t matter to some of these players because they can make money whether the roller coaster is going up or going down.

    Not a co-incidence that Wall St is now handing out million dollar bonuses again after big investment banks were saved by tax payers’ monies.

    Question – how will Blanchard survive in his role if he really means what he says?

  4. @Wilbur: I am generally pro-trade as long as the terms of the deal are fiar and on-exploitative. The Malaysia FTA, like th China FTA, has the potential to be of significant benefit to NZ.

    @ Loota: Well Mr Blanchard has stirred up a hornets next – go search IMF Online or FT Online. I can’t imagine he didn’t clear his lines before writing. And you are absolutely right about the crazy levels of financial leverage (and mis-priced risk)that were around pre-crash.

  5. Spud says:

    I can’t wait to have you guys back to the government benches :-D

  6. Phil says:

    Question – how will Blanchard survive in his role if he really means what he says?

    The IMF has a long history of publishing discussion papers and articles on a wide variety of economic topics, with an equally wide variety of viewpoints and possible solutions to problems discussed within them.

    There is no ‘hornets nest’ being stirred up.

  7. “Stable inflation may be necessary but is not sufficient. Housing bubbles, current account deficits and consumptions binges are serious problems.”

    There is little the government can do about these issues short of fundamentally meddling with the economy and compulsary super… Can’t really stop people from paying too much for houses or consuming more than they can afford…

    It’ll be nice to see a balanced budget again, hopefully sooner rather than later… If we get GFC – part 2 that’ll be a pipe dream and we’ll need an emergency budget with some big painful measures…

  8. Quoth the Raven says:

    The financial markets are the most regulated markets in history. In the US there are thousands of regulations over a hundred different regulatory agencies. The great increase in financialization occurred in a heavily regulated environment. More regulation isn’t going to prevent another financial crisis. The endless flow of cheap money from central banks is the problem.

  9. Loota says:

    Quoth, things like CDO’s were largely invisible to the regulators. This financial crisis did not occur due to the heavily regulated and long established shares and futures markets but in these ‘invisible derivatives’.

    A hundred different regulatory agencies – yes, but each with only a tiny portion of the picture, many not even talking to each another, and some deliberately captured by those they were supposed to be regulating.

    There was the whistleblower whom over a number of years fed the SEC mounting evidence and information that Madoff was running a total fraud – this whistleblower figured it out because no one could give perfect returns year after year after year who was truly investing clients’ money in a real market place – he was ignored by the chiefs of the SEC for years.

    The cops simply weren’t on the beat.

    And yes, hot cheap money from central banks was a big part of the issue, but then these firms leveraged the housing assets that hot money bought to 30:1 and 35:1 levels, and then misrepresented the investment worthiness of the resulting securities they created.

    They painted lead gold and sold it on at the price of gold.

  10. Loota says:

    There is little the government can do about these issues short of fundamentally meddling with the economy and compulsary super… Can’t really stop people from paying too much for houses or consuming more than they can afford…

    Of course you can. And meddle if you have to, so what.

    Use capital gains taxes, windfall taxes, force banks to require larger deposits on property, stop hot money flowing into the country, remove tax breaks from flipping houses and property investments, ensure building compliance codes are water tight and difficult to meet,… the list oges on and on and on

  11. Loota says:

    Increase consumer credit protections, force finance companies to require higher standards of credit worthiness and income before giving out loans, introduce and enforce new laws around credit cards e.g. minimum payments and preapproved credit, popularise models of being which don’t revolve around consumerism,…list goes on and on

  12. Huginn says:

    @ Quoth the Raven:
    When people talk about the de-regulation of the financial markets that contributed to the recent financial crisis, they are often referring to the Gramm-Leach-Bliley Act (GLBA), also known as the Financial Services Modernization Act of 1999 which repealed part of the Glass-Steagall Act of 1933 in the USA.

    The Glass-Steagall Act prohibited any one institution from acting as any combination of an investment bank, a commercial bank, and an insurance company.

    The GLBA opened up the market among banking companies, securities companies and insurance companies by allowing commercial banks, investment banks, securities firms, and insurance companies to consolidate.

    There is, of course a lively debate as to whether or not the GLBA contributed to the financial crisis, and if so, in what way. But in the aftermath of this repeal, I don’t think that it is accurate to say:

    ‘The financial markets are the most regulated markets in history.’

  13. When one abandons principles for rules (as the US did), smart people always find a way through the rules.

  14. Anasazi says:

    Loota has some good points. I have always been amazed how money makes money without actually doing anything or producing anything useful.

  15. DeepRed says:

    @Anasazi: a few hundred years ago it was called Tulipmania. Nothing’s changed much.

  16. Loota says:

    Shane said:

    When one abandons principles for rules (as the US did), smart people always find a way through the rules.

    Yep this is very true.

    Especially if those same people were the ones who drafted up the rules in the first place.

  17. @Loota, your list for property does not in anyway stop people paying too much for houses – if anything they’ll increase prices and have a detrimental effect throughout the economy…

    Your credit list could help ensure people aren’t being encouraged to overconsume but they don’t fundamentally stop people from doing it…

    People are going to have to choose to pay realistic prices for houses and stop overspending or the government will eventually have to use force – which will be very bad for all of us…

  18. Loota says:

    JMH – well, I agree, it doesn’t stop people from physically going to the store to buy something, but it changes the levels of incentive and provides pricing signals to people.

    People are going to have to choose to pay realistic prices for houses and stop overspending or the government will eventually have to use force – which will be very bad for all of us…

    Can’t ignore the fact that cheap money at no deposit can help people get into houses and property developments they are over leveraged on and cannot afford when times turn a bit toughter.

    This ‘people are going to have to choose…’ well we must realise that people make their choices within an environment and a context that can be altered. Hands off lassez faire is the neocon free market approach.

  19. I think in both cases compulsary super will help, as well as a core financial literacy class in 3 – 5 form…

    I’m no lassez fairite, I support compulsary super and copying the French Health System (which involves compulsary health insurance)…

    Compulsionary savings and health insurance programmes as a percentage of salary (with the government picking up the tab for the less fortunate) seems to work well to me, in the current set up unless people start to choose to not spend money they don’t have and choose to not put all their investment money into a housing market (because they distrust shares) that no longer reflects reality, then the government will reach a point where it must be use some form of force or major economic reform to ensure the long term viability of our economy, compulsion or reform will be painful…

  20. Quoth the Raven says:

    Huginn – In terms of the amount of regulation and oversight it is simply a statement of fact to say that the financial markets are the most regulated in history.

    Loota – Regulation/deregulation of the banking system and the free market is a red herring. The banking system works in the context of central banking. Cheap money is not simply a problem it is the root cause of the problem. Central banks inflate the money supply and the fractional reserve system they foster simply creates money out of thin air leading to credit bubbles. I’ve got no problem with more regulation of banks within the context of the present central bank-fractional reserve banking system we have,(the free market is neither here nor there because of it) but it is misguided to think that more regulation would prevent another financial crisis when the fundamentals of the system remain in place. Here is a quote from Murray Rothbard and he is as much a free marketeer as they come

    Many free-market advocates wonder: why is it that I am a champion of free markets, privatization, and deregulation everywhere else, but not in the banking system? The answer should now be clear: Banking is not a legitimate industry, providing legitimate service, so long as it continues to be a system of fractional-reserve banking: that is, the fraudulent making of contracts that it is impossible to honor.

  21. Loota says:

    In the context you have given Quoth I think you make a good point and cheap hot money is where problems start. A proximal to pay attention to however is how these monies are then over-leveraged. Having said that, I’ve no problem with your concept of starting work on the problem from the central bank.

  22. I’m guess you’re advocating free currency QTR..?

  23. Richard Shaw says:

    @Jeremey H Harris

    Ive spent a bit of time in French Hospitals (Private); they are very good. Single payer insurance is good; although I do worry about the industry of denial; even in a state system, like what we are seeing in ACC now, due to tough financial times.

  24. Just like with super, health cost for the nation are going to soar as the baby boomers retire, we haven’t saved enough and due to the size of the baby boomer group, environmental issues and the GFC we likely cannot grow enough keep entitlements at current levels, at current taxes for much longer… The sooner we change to compulsary health insurance and super…

    We can of course take solace by looking at the Americans and Europeans, but don’t look over the ditch…