It has become very clear macro economists confuse correlation with causation.

Since it was first introduced by Keynes, macro economists have told a story about how increasing government spending and decreasing interest rates are the policy prescription of choice for getting an economy out of a recession or depression and onto a self-sustaining recovery.

It is a great story except for one small problem.  It ignores banks and the bad debt in the financial system when a financial crisis occurs.

Given this problem, is the Economists’ policy prescription really the right policy response to a financial crisis?

I can hear the macro economists howling already about how this question is unfair.  Why is it unfair?  Because in answering the Queen’s Question about why they didn’t see the financial crisis coming, macro economists freely acknowledge Economic theory and the stories they tell based on it shows a financial crisis is hard to predict.  This is a major problem because if the theory doesn’t shed light on when a financial crisis is likely there is no reason to think the theory sheds light on how to respond to a crisis.

Let me say this in a different way.  Recommending increasing government spending and decreasing interest rates when a financial crisis occurs is much like recommending someone with a cold eat chicken soup.  It is far from clear the chicken soup is going to cure the cold or the policy recommendations are going to end the financial crisis.

The fact the individual or real economy recovers could be entirely independent of the chicken soup or policy recommendations.  There could be another factor that explains the recovery of an individual’s health or the real economy.  This is true despite the fact there is a positive correlation between the recommendation (soup/spending increase/interest rate decrease) and the recovery.

Of course, financial crises and their aftermath confirm this positive correlation is superficial.  We find economic growth spurred by the Economists’ policy recommendations does not translate to the ultimate policy objective of a self-sustaining recovery.

It isn’t just me pointing this out.  Brad DeLong observed:

The crisis and its aftermath showed that the North Atlantic economies could not maintain full employment by following the Keynesian road. The idea that when the private sector sits down the public sector should stand up—that consistent durable prosperity can be achieved by having government step in as a spender of last resort—proved unsustainable. It also showed that full employment could not be maintained by following the monetarist road: the idea that successful regulation could keep finance on a sound footing, or at least a steady enough footing for central banks to manage, also proved unsustainable.

Regular readers know I like to look at how Japan and Sweden/Iceland responded to their financial crises.

For almost three decades, Japan has been responding to its financial crisis with the economists policy recommendations of increased government spending and decreased interest rates.  The positive correlation between these policies and economic growth continues to exist.  However despite doubling, tripling and going to extremes in following the policy recommendations, a sustainable economic recovery is still nowheres in sight.  Hmmmm…..

On the other hand, Sweden in the 1990s and Iceland in the late 2000s responded to their financial crises with a different approach.  Their approach featured requiring their banks to absorb the losses on their bad debt exposures at the start of the crisis.  They also implemented the economists’ policy recommendations.  Within 24 months each of their economies enjoyed a self-sustaining recovery.  Hmmmm….

If you looked at the response by country to the acute phase of the Great Financial Crisis, you could put each country on a scale from made their banks take losses to saved their banks from taking any losses.  Those countries that made their banks take losses either achieved or are close to achieving a self-sustaining recovery.  Those countries that saved their banks have economies that are still dependent on fiscal/monetary stimulus.

Is there reason to think using the banks to absorb losses accounts for the success or failure in achieving the ultimate policy objective of a self-sustaining recovery?

Yes.

When the banks absorb the losses, it removes from the real economy the burden of supporting the excess debt.  This burden takes several forms including:  reducing demand as the actual debt payments take money out of the hands of individuals with a high propensity to consume; and creating zombie borrowers (capable of generating cash to service some of the debt, but not enough cash to repay the debt) who undermine the economics of the industries they are in.

Of course, in the models used by economists, banks are left out.  Banks also are not in their story.  So it is not surprising making banks recognize losses isn’t the focus of their policy recommendations.

Instead, economists come up with stories for why it takes a long time to recover from a financial crisis when their policy recommendations are followed.  A story economists should know isn’t true.

After the Panic of 1907, the Fed with its lender of last resort capabilities was established.  During the Great Depression, deposit insurance was adopted.  Together they make it possible for banks to take losses and for insolvent banks to continue in operation providing loans and payment services indefinitely (see mid-1980s Savings and Loan Crisis).

As a result, the policy response of forcing banks to take losses at the start of a financial crisis is the textbook response.  It results in a quick resumption of a self-sustaining recovery.

Of course, it just doesn’t happen to be in macro economists playbook. They are still telling the story fiscal stimulus and accommodative monetary policy will cause a recovery.  We just have to do more of it.