After a decade of being derided for their failure to predict the financial crisis, macro economists want us to stop criticizing them and recognize how valuable their policy recommendations were.
Fair enough. Let’s see what policy recommendations macro economists made during the acute phase of the financial crisis they didn’t see coming.
Simon Wren-Lewis provided us with a nice summary of these recommendations and the result of their recommendations:
Immediately after the financial crisis interest rates would not have been cut and austerity would have started in 2009, not 2010. Banks would have gone bust because economists said we needed to bail them out. In which case the Great Recession would have become the second Great Depression….
So comparing this thought experiment with reality, we can see that economists have prevented a rerun of the 1930s depression…
Note the framing of these recommendations is the macro economists heroically prevented a rerun of the 1930s depression.
Forgive my asking, but is it possible the people who lived through the Great Depression redesigned the global financial system and took other steps to prevent a second Great Depression from ever happening? After all, it they did, then the claim of preventing a rerun is patently false.
Is there any reason to think the people living in the 1930s and 40s would have done such a thing? Yes. They did so and they did so in a way where they prevented another Great Depression.
What did they do? They introduced deposit insurance and the social safety net.
Deposit insurance is a really, really, really important development.
Why? Because it allows banks to continue in operation for years as they go from solvent to insolvent and back to solvent. Without deposit insurance, an insolvent bank goes out of business as the result of a liquidity shortfall (technically known as a bank run). With deposit insurance, the taxpayer becomes the insolvent bank’s silent equity partner. Hence, no reason to run to get your deposits back.
So how does deposit insurance impact the handling of a financial crisis?
It allows the authorities to clean out all the bad debt in the financial system at the start of the crisis. Simply put, banks recognize the losses on all their bad assets (technically known as the Swedish Model).
This was done in Sweden in the 1990s when they had a financial crisis and they didn’t see a rerun of the Great Depression. This was done in Iceland in 2008/2009 when they had a financial crisis and they didn’t see a rerun of the Great Depression. In fact, both economies recovered quickly with no signs of the economic malaise Japan has experienced since it followed the macro economists’ bailout recommendations and decided not to use the financial system as it is designed, but rather saved its banks and not the real economy.
Doesn’t recognizing all the losses on the bad debt in the financial system wipe out bank capital? Yes, but with deposit insurance depositors don’t cares. They know they will get their money back. What about the unsecured debt holders? They know they are better off if the bank continues in operation. What about the shareholders? They expect to lose their investment if the bank is closed so they are better off because there is a potential recovery at some point in the future.
Having absorbed the losses, the banks then continue on in the business of making loans. Their pre-banker bonus earnings are retained until such time as their book capital has been rebuilt. Please note, there is no real world operational reason banks have to always have positive book capital. Book capital is an accounting construct. However, there is a regulation that says banks should have positive book capital, but this regulation would be easy to suspend during the time banks are rebuilding their book capital following a financial crisis.
The critically important point I am making is deposit insurance allows policymakers to keep the financial crisis in the financial system and protect the real economy from any fallout.
A social safety net is also a really, really, really important development.
Why? The social safety net guarantees the real economy keeps functioning while the losses in the financial system are being sorted out. This is important because it prevents a recession from turning into a depression.
Clearly, the macro economists policy recommendations did not prevent a rerun of the 1930s. But is it possible the macro economists’ policy recommendations made the recovery from the financial crisis worse than it had to be?
They championed bailing out the banks so they didn’t go bust. How was explicitly injecting taxpayer funds into the banks remotely helpful given the taxpayers were already the banks’ silent equity partner as a result of deposit insurance?
In fact, it made it impossible for the authorities to clean out all the bad debt in the financial system as the losses on this bad debt exceeded the amount of money the taxpayers put up to bailout the banks. A decade after the financial crisis and RBS is still cleaning up its balance sheet.
By not cleaning up the bad debt, the impact of the financial crisis was pushed onto the real economy. It took many forms, one of them zombie corporations who couldn’t repay their debt, but could destroy the profit structure of each industry they were in.
I cannot blame macro economists for this faulty recommendation. There was no reason to think they had any idea of how the financial system was designed given the fact they excluded the financial system from their models.
However, I can blame macro economists for making recommendations for how to regulate the financial system in the aftermath of the financial crisis. Since they didn’t have any idea of how the financial system was designed before the crisis, there was no reason to think when they opened their mouths after the crisis hit their recommendations was based on relevant facts and not a random set of assumptions supporting whatever they wanted to see happen.
Take bank capital as an example. Macro economists championed higher capital levels. Sounds good in theory, but it is only good in theory. First, bank capital is an easily manipulated, meaningless accounting construct (thanks to OECD for emphasizing just how meaningless). Regulators manipulate bank capital when they allow banks to engage in “extend and pretend”. Banks manipulate bank capital when they move securities from mark to market trading accounts to hold to maturity portfolio accounts.
More importantly, the focus on high levels of bank capital works against using the bank capital accounts as they are designed to absorb the losses on the bad debt in the financial system. As shown at the start of our financial crisis, bank regulators are reluctant to make banks take losses for fear the lower capital accounts will trigger financial panic.
Macro economists also championed lower interest rates. How were zero interest rates and quantitative easing helpful given Walter Bagehot (modern central banking is based on his ideas) and Keynes (another expert in financial crises) said interest rates shouldn’t go below 2% as they create their own economic headwinds? They weren’t.
Those low rates have had a negative impact on the economy. The BIS summarized this negative impact:
These include adverse effects of low rates on bank profitability and ultimately on credit supply as net interest margins become compressed; a potential increase in savings if low interest rates render agents’ envisaged lifetime savings insufficient to ensure an adequate standard of living after retirement; resource misallocation driven by low interest rates, e.g. through zombie lending by banks; and negative confidence effects, as persistent low rates could be perceived as a negative signal about economic prospects.
Left off the list was the inequality ZIRP and QE created.
This faulty recommendation falls squarely on the macro economists. There was no reason not to have built in Bagehot and Keynes’ observation about 2% as the lower bound for interest rates right into their models. Instead, their models assumed the relationships that held above 2% also held below 2%. Clearly this is not true and the consistent projection of a much stronger recovery than has occurred confirms the change Bagehot/Keynes said would happen has happened.
But not every policy recommendation made by macro economists made the post-crisis recovery worse. They deserve significant credit for saying austerity was a truly bad idea.
But I don’t want to go too far giving them credit because this might simply be a case of even a blind squirrel occasionally finding an acorn.
At a minimum, given Wren-Lewis got to choose the crisis era policy recommendations macro economists are most proud of, this track record does not suggest macro economists should exhibit the degree of hubris they do. Nor does this track record suggest macro economists are deserving of any special status or should be listened to when they offer up suggestions for how to regulate the financial system.