Getting the Financial Crisis Narrative Right
By now, everyone has their favorite narrative to explain the financial crisis and the effectiveness of the policy response to it.
It could be the false narrative of the Committee to Save the Banks which claimed they were acting as firefighters putting out a panic no one could have predicted. It could be the equally ridiculous narrative if only banks had more capital then the Committee to Save the Banks wouldn’t have had to rewrite the social contract and bailout bankers and the 1%. It could even be the more farfetched narrative traditional macroeconomic models like the IS-LM analysis were useful in understanding the crisis and how to respond.
However, no matter how much you like your favorite narrative, it doesn’t mean this narrative is correct. For a narrative to be correct, it has to explain why the crisis happened the way it did. You aren’t allowed to leave out inconvenient facts because the narrative cannot explain them. The narrative also has to explain how a financial crisis should be responded to and why the policy response worked/didn’t work. Finally, the narrative has to explain how to prevent future financial crises.
For brevity, I’ll limit myself to debunking Nobel prize winner Paul Krugman’s latest narrative. He asks the question “what do we actually know about the economy” and offers up
The overall story, then, is one of overwhelming predictive success. Basic, old-fashioned macroeconomics didn’t fail in the crisis – it worked extremely well. … But, you say, we didn’t see the Great Recession coming. Well, what do you mean “we,” white man?
While I like his snarky commentary, he proceeds to undermine his claim to having seen the Great Recession coming.
OK, what’s true is that few economists realized that there was a huge housing bubble. But that’s not a failure of fundamental models: the models certainly would have predicted that a bursting bubble that slashed residential investment by 4 percent of GDP and destroyed $7 trillion in homeowners’ equity would cause a severe recession.
Why didn’t you and the Economics profession use these fundamental models to see what the impact of the bubble bursting would be?
What happened was that economists refused to believe that home prices could be that out of touch with reality. That’s not exactly a problem with macroeconomics; to some extent it’s a problem with financial economics, but mainly I think it reflected the general unwillingness of human beings (a category that includes many though not necessarily all economists) to believe that so many people can be so wrong about something so big.
On the one hand, Professor Krugman knew it was a bubble. On the other hand, he underestimated the size of the bubble because of a refusal to believe prices could be out of touch with reality.
Forgive me, but what is out touch with reality is Professor Krugman and macroeconomics.
What does his housing bubble narrative suggest the policy response to the crisis should have been? Lots of fiscal stimulus and accommodative monetary policy.
Really?
While it might replace the 4% of GDP lost when the housing bubble popped, how is this response going to relink home prices with reality? Short answer, it doesn’t.
How is this response going to limit growth in inequality? Short answer, it doesn’t.
As I said earlier, the right narrative explains the financial crisis without leaving out any inconvenient facts.
Regular readers already know the Information Matrix provides the right narrative. Not only does it explain why the financial crisis happened the way it did (it was an earthquake along the opacity fault line), it explains the policies that should have been pursued (the Swedish Model under which banks take losses), it explains why the policies that were pursued effectively rewrote the social contract and based on the rise of populism and inequality haven’t really worked (the Committee to Save the Banks pursued the Japanese Model under which the banks and bankers were protected at all costs), and it explains how to prevent future financial crises (restoring transparency across the global financial system).
So why doesn’t the Economics profession and Professor Krugman accept the Information Matrix and the related narrative? Professor Krugman provides the answer.
Over this past decade, I’ve watched a number of economists try to argue from authority: I am a famous professor, therefore you should believe what I say. This never ends well….
Absolutely correct. It has never ended well. A case in point would be the call for higher bank capital requirements championed by professors from Stanford and MIT.
Economists haven’t earned the right to be snooty and superior, especially if their reputation comes from the ability to do hard math: hard math has been remarkably little help lately, if ever.
Absolutely correct. Economists have spent a decade trying to find a narrative and still don’t have one that works as well as the Information Matrix.
On the other hand, economists do turn out to know quite a lot: they do have some extremely useful models, usually pretty simple ones, that have stood up well in the face of evidence and events. And they definitely shouldn’t defer to important and/or rich people on policy: compare Janet Yellen’s macroeconomic track record with that of the multiple billionaires who warned that Bernanke would debase the dollar. Or take my favorite Business Week headline from 2010: “Krugman or [John] Paulson: Who You Gonna Bet On?” Um.
The important thing is to be aware of what we do know, and why.
I agree with Professor Krugman the important thing is to be aware of what economists do know and why. What economists don’t know is anything about the Information Matrix, why the financial system is designed the way it is, how to respond to a financial crisis and how to prevent a financial crisis.
Other than that, I would say macroeconomics has performed exceptionally well since the acute phase of the financial crisis began with the collapse of Lehman Brothers a decade ago.
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