How the official strategists were in denial

Now that the Great Recession is over, we can review how successful the official leaders of capitalist economic strategy were in forecasting the financial crisis, in dealing with it when it came and what they learnt afterwards.  The answers are unsurprisingly depressing.

Before 2007, no official strategist of economic policy forecast any crisis.  US Fed Chairman Greenspan in 2004 told us that “a national severe price distortion is most unlikely in real estate”.  In 2006, he told us that “the worst may be over for housing”, just the housing bubble burst.  US treasury secretary Hank Paulson said the crisis in the overall economy “appears to be contained”, March 2007.

During the crisis, in October 2008, the great financial maestro Greenspan told the US Congress, “I am in a state of shocked disbelief.” He was questioned: “In other words, you found that your view of the world, your ideology was not right, it was not working (House Oversight Committee Chair, Henry Waxman).  “Absolutely, precisely, you know that’s precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well”.

Greenspan in hindsight tells us that economists cannot predict a bubble and when it happens there is nothing you can do about it.  “You can only break a bubble if you break the underlying basis of the economy”. October 2007.

Greenspan finally summed up what he had learned a review of the crisis in his paper The Crisis, March 2010.  He told us that what happened was “financial intermediation tried to function with too thin a layer of capital owing to a misreading of the degree of risk embedded in ever-more complex financial products and markets “.  So something as simple as the lack of capital adequacy in the banks was the cause.  You’d think he might have noticed that.

Moreover, the bubble that burst in 2008 came about by a conjunction of events that could not be expected.  It was the serendipity of the Fall of the Wall, cheap interest rates and globalisation that came together to create excessive risk taking.  Could the crisis have been avoided?  “No, because of these serendipity factors coming together, I doubt it”, he says.

So for Greenspan, it was chance, a one hundred year event.  “The disasters were the results of massive natural forces and they did constitute a perfect storm”. This idea was echoed by Hank Paulson: this sort of thing happens “only once or twice” in a hundred years.  As economist Daniel Gross commented on the ‘chance explanation’ of the crisis: what’s the difference between once or twice?  “In this instance, several trillion dollars in losses”. The IMF puts the latest figure at about $3trn, of which about two-thirds has been realised so far.

In the aftermath, the official leaders fell back on the argument of Nassim Taleb, in his book, Black Swan (see my book, The Great Recession) that the crisis was a black swan – something that could not have been expected or even known until it was, and then with devastating consequences (4).  As Donald Rumsfeld put it, when asked about the Iraq war, it was an ‘unknown unknown’.

Greenspan defined a bubble as “a protracted period of falling risk aversion that translates into falling capital rates that decline measurably below their long-run trendless averages.  Falling capitalisation rates propel one or more asset prices to unsustainable levels.  All bubbles burst when risk aversion reaches its irreducible minimum.”

He notes that several Nobel prize winners in economics were embracing profitable market trading models that were successful only as long as risk aversion ‘moved incrementally’.  But using only 2 to 3 decades of data did not yield a model that could anticipate crisis if risk moved outside that range.  There was nothing wrong with the Black and Scholes option pricing model: “it’s no less valid today than a decade ago”. It is just that the “underlying size, length and impact of the negative tail of the distribution of risk outcomes that was about to be revealed” had not been comprehended.

In his paper on The Crisis, Greenspan now doubts that stable growth is possible under capitalism (5).  “I know of no form of economic organisation based on the division of labour (he refers to the Smithian view of an economy), from unfettered laisser-faire to oppressive central planning that has succeeded in achieving both maximum sustainable economic growth and permanent stability.  Central planning certainly failed and I strongly doubt that stability is achievable in capitalist economies, given the always turbulent competitive markets continuously being drawn toward but never quite achieving equilibrium”.

He went on, “unless there is a societal choice to abandon dynamic markets and leverage for some form of central planning, I fear that preventing bubbles will in the end turn out to be infeasible.  Assuaging the aftermath is all we can hope for.”

Of course, these official leaders are the paid proponents of vulgar economics.  You would not expect them forecast to the public at large that capitalism was about to collapse or could collapse.  The Fed failed to foresee the greatest economic collapse since the Great Depression.  And it is not surprising.  There is a crude pecuniary connection here.  At the Journal of Monetary Economics, a much-published venue of mainstream economics, more than half of the editorial members are currently on the Fed payroll and the rest have been in the past (7).  There were 730 economists, statisticians and others working at the Fed and its regional banks in 1993, according Greenspan.

Over a three-year period, ending October 1994, the Fed awarded 305 contracts to 209 professors worth $3m.  The Fed now employs 220 PhD economists.  In 2008, the Fed spent $389m on research into monetary and economic policy and $433m was budgeted for 2009.  According to the AEA, 487 economists are researching monetary policy and central banking, another 310 on interest rates; 244 on macroeconomic policy.

The NABE reckons that 611 of its 2400 members focus on monetary and banking.  Most of these have worked for or with the Fed.  Many editors of prominent academic journals are on the Fed payroll: 84 out of 190 editorial members in seven top economics journals were affiliated with the Fed.

“Try to publish an article critical of the Fed with an editor who works for the Fed” complained economist James Galbraith.  Even the now extinct Milton Friedman expressed his concerns about this:  “I cannot disagree with you that having something like 500 economists is extremely unhealthy.  As you say, it is not conducive to independent objective research.  There is censorship of material published.”

Asked to be a consultant for the Fed. “It’s a payoff, like money.  I think it’s more being one of part of a club, being respected, invited to conferences, have a hearing with the chairman, having the prestige is as much as a pay check.” Rob Johnson, Senate banking committee economist.

Ben Bernanke is the current Fed chairman and presided over the Great Recession.  Bernanke is an economist who specialised in the Great Depression.  If ever there was an economist who looked at ‘depression economics’, to use Krugman’s phrase, it is Bernanke.

He concluded that depression could be avoided by Fed action.  Following his mentor Milton Friedman, he advocated printing money and even ‘dropping it from helicopters’ to the populace to ensure spending is sustained.  This monetarist theory led him to concentrate on money supply indicators as a guide to the state of the US economy.  “I would like to say to Milton Friedman and Anna Schwartz regarding the Great Depression.  You are right, the US had a Great Depression, but thanks to you, we won’t again”“  Bernanke, 2002 speech.  But “Mr Bernanke, the former head of Princeton University economics department, knows all there is to know about a depression except what causes them” (8).

Like Greenspan, Bernanke did not see the crunch coming.  “We don’t expect significant spillover from the subprime market to the rest of the economy from the financial system”. May 2007.  By June, he was saying the losses would be minimal “between $50-100bn” at most.  So far, the losses in the global financial system have reached just under $2trn (see above).

The head of the Federal Deposit Insurance Corporation, a US government agency responsible for regulating and monitoring the banking system, reported in July 2007 that “the banks in this country are well capitalised and my view is that I would be very, very surprised if any institutions of significant size were to get into serious trouble.” And lo – we then had Bear Stearns, Countrywide, Lehmans, Merrill Lynch etc.

The efficacy of the economics of the world’s financial leaders in the Great Recession has been neatly summed up.  “Central banks have shed the conventional wisdom of typical macroeconomics.  But in its place is a pot pourri of factoids, partial theories, empirical regularities without formal theoretical foundations, hunches, intuitions and half-developed insights.” (9)

It does not leave you with much confidence in the future policies of the strategists of capital.

4.  Nassim Taleb, The Black Swan, 2009

5.  Alan Greenspan, The Crisis, March 2010

6.  op cit, p46

7. Ryan Grim, Huffington Post, 12 March 2010-05-04

8.  Bill Bonner, Gloom, Boom and Doom report, March 2010.

9.  The unfortunate uselessness of most of state of the art academic monetary economics, FT 3 March 2020