How to misunderstand crises... with Rational Expectations

** UPDATE BELOW ** I've just about finished Gary Gorton's excellent book Misunderstanding Financial Crises. I think it's the most convincing book I've read so far that links the mechanisms of the recent crisis to crises in the past. In effect, he argues that the crisis was the direct result of the uncontrolled creation of money by the shadow banking sector, and ultimately took place as a classic bank run, no different from runs in the past, except that this run took place mostly out of public view because it didn't involve ordinary bank deposits. The new kind of money in this bank run was stuff such as repo agreements and commercial paper which played the role of money for financial institutions. In 2007-2008, when lenders lost confidence (for good reason) in the mortgage-backed collateral backing this money, they demanded that money back, and the financial system seized up.

The explanation is convincing and wholly natural. The argument is most convincing because Gorton does a masterful job of placing this bank run in the context of the long history of past runs. And also because Gorton, as an economist, places blame squarely on the economics profession (himself included) for being asleep at the wheel:

Think of economists and bank regulators looking out at the financial landscape prior to the financial crisis. What did they see? They did not see the possibility of a systemic crisis. Nor did they see how capital markets and the banking system had evolved in the last thirty years. They did not know of the existence of new financial instruments or the size of certain money markets. They did not know what "money" had become. They looked from a certain point of view, from a certain paradigm, and missed everything that was important... The blindness is astounding. That economists did not think such a crisis could happen in the United States was an intellectual failure.

It seems to me that there is a certain amount of denial among economists. I have noticed, in talking about the ideas in this book with my economist colleagues, that there is a fairly clear generational divide on this. To younger economists and graduate students, it is obvious that there was an intellectual failure. Some older economists are inclined to hem and haw, resorting to farfetched rebuttals. It is clear that this is a sensitive issue, as like banks no one wants to have to write down the value of their capital.

The book gets rather technical in places talking about the details of day to day financing on Wall St., but all in a way that adds credibility to the main argument.

One other thing of interest. Gorton in a late chapter, when discussing the spectacular failure of the rational expectations paradigm, quotes University of Chicago economist James Heckman, winner of the economics' Nobel Prize (yes, that's not its actual name) in 2000, from an interview he did with John Cassidy in 2010. I hadn't come across the interview before. It's a fascinating read and gives some interesting perspective on varied views held by economists within the Chicago department (Cassidy's words in italics):

What about the rational-expectations hypothesis, the other big theory associated with modern Chicago? How does that stack up now?

I could tell you a story about my friend and colleague Milton Friedman. In the nineteen-seventies, we were sitting in the Ph.D. oral examination of a Chicago economist who has gone on to make his mark in the world. His thesis was on rational expectations. After he’d left, Friedman turned to me and said, “Look, I think it is a good idea, but these guys have taken it way too far.”

It became a kind of tautology that had enormously powerful policy implications, in theory. But the fact is, it didn’t have any empirical content. When Tom Sargent, Lard Hansen, and others tried to test it using cross equation restrictions, and so on, the data rejected the theories. There were a certain section of people that really got carried away. It became quite stifling.

What about Robert Lucas? He came up with a lot of these theories. Does he bear responsibility?

Well, Lucas is a very subtle person, and he is mainly concerned with theory. He doesn’t make a lot of empirical statements. I don’t think Bob got carried away, but some of his disciples did. It often happens. The further down the food chain you go, the more the zealots take over.

What about you? When rational expectations was sweeping economics, what was your reaction to it? I know you are primarily a micro guy, but what did you think?

What struck me was that we knew Keynesian theory was still alive in the banks and on Wall Street. Economists in those areas relied on Keynesian models to make short-run forecasts. It seemed strange to me that they would continue to do this if it had been theoretically proven that these models didn’t work.

What about the efficient-markets hypothesis? Did Chicago economists go too far in promoting that theory, too?

Some did. But there is a lot of diversity here. You can go office to office and get a different view.

[Heckman brought up the memoir of the late Fischer Black, one of the founders of the Black-Scholes option-pricing model, in which he says that financial markets tend to wander around, and don’t stick closely to economics fundamentals.]

[Black] was very close to the markets, and he had a feel for them, and he was very skeptical. And he was a Chicago economist. But there was an element of dogma in support of the efficient-market hypothesis. People like Raghu [Rajan] and Ned Gramlich [a former governor of the Federal Reserve, who died in 2007] were warning something was wrong, and they were ignored. There was sort of a culture of efficient markets—on Wall Street, in Washington, and in parts of academia, including Chicago.

What was the reaction here when the crisis struck?

Everybody was blindsided by the magnitude of what happened. But it wasn’t just here. The whole profession was blindsided. I don’t think Joe Stiglitz was forecasting a collapse in the mortgage market and large-scale banking collapses.

So, today, what survives of the Chicago School? What is left?

I think the tradition of incorporating theory into your economic thinking and confronting it with data—that is still very much alive. It might be in the study of wage inequality, or labor supply responses to taxes, or whatever. And the idea that people respond rationally to incentives is also still central. Nothing has invalidated that—on the contrary.

So, I think the underlying ideas of the Chicago School are still very powerful. The basis of the rocket is still intact. It is what I see as the booster stage—the rational-expectation hypothesis and the vulgar versions of the efficient-markets hypothesis that have run into trouble. They have taken a beating—no doubt about that. I think that what happened is that people got too far away from the data, and confronting ideas with data. That part of the Chicago tradition was neglected, and it was a strong part of the tradition.

When Bob Lucas was writing that the Great Depression was people taking extended vacations—refusing to take available jobs at low wages—there was another Chicago economist, Albert Rees, who was writing in the Chicago Journal saying, No, wait a minute. There is a lot of evidence that this is not true.

Milton Friedman—he was a macro theorist, but he was less driven by theory and by the desire to construct a single overarching theory than by attempting to answer empirical questions. Again, if you read his empirical books they are full of empirical data. That side of his legacy was neglected, I think.

When Friedman died, a couple of years ago, we had a symposium for the alumni devoted to the Friedman legacy. I was talking about the permanent income hypothesis; Lucas was talking about rational expectations. We have some bright alums. One woman got up and said, “Look at the evidence on 401k plans and how people misuse them, or don’t use them. Are you really saying that people look ahead and plan ahead rationally?” And Lucas said, “Yes, that’s what the theory of rational expectations says, and that’s part of Friedman’s legacy.” I said, “No, it isn’t. He was much more empirically minded than that.” People took one part of his legacy and forgot the rest. They moved too far away from the data.

** UPDATE **

On a closely related note, check out between 18:00 and about 20:25 of this video documentary on debt and its primary role in the crisis, link courtesy of Lars Syll. Robert Lucas asserts (around 19:40) that debt just doesn't matter because the level of debt and credit always "cancels out." He seems to think it is strange that anyone could even think that debt should matter, as if he's completely blind to the massive agony and social upheaval ensuing from foreclosures and failed businesses around the US and the world. Lars suggests this is "unbelievable stupidity" and it is certainly unbelievable, but I think maybe it is less stupidity and reflects more a kind of borderline autistic inability to make a distinction between some extremely abstract mathematical model and actual economic reality. In Lucas's models, I suspect that debt and credit do always cancel out. Which is one aspect of what makes those models quite useless for many purposes, and dangerous in the hands of anyone who takes them too seriously.  

What's going on in Greece

Numerian, one of the most insightful financial bloggers I know, gets to the bottom of the markets' surge in the wake of the Greek passage of the new "austerity" measures:

For now, stock markets are happy because they get their periodic injection of heroin – oops, make that “liquidity” – to keep the game going. The game is the one we have all lived through our whole lives – the one where capitalism continues to grow by taking on more and more debt, until now every country is at the point where only the government is big enough to take on the enormous amounts of new debt necessary to keep paying principal and interest on the old debt. At least some countries are: the United States, the UK, Germany, France. Greece of course lost that privilege several years ago, and now even big borrowers like Italy are allowed into the markets only for very short term maturities.

The game, in short, is about over, choking to death on too much debt, kept on a resuscitator by politicians and central bankers who know the public has no way to stop them from raising trillions of dollars or euros with new bond issues. Only the market can stop an out-of-control debtor. Greece has found that out, Italy and Spain and Portugal are close to finding that out, and the UK and the United States are on the list, being no more virtuous than the Greeks. Once the government can no longer borrow, default in some form is inevitable, and austerity follows. The Greeks have austerity handed to them by the Germans; everyone else will be able to choose their own forms of austerity, as different economic and social forces fight with each other in a country that has run out of borrowing capacity and must live off the taxes it is able to raise.

If the stock market had a long term view, it would think about these things. It would look at Greece as a combination horror story and warning sign. Instead, the stock market lives for the day only, and for now the debt binge continues, and the fix of easy credit is being pumped into the financial system once more. Let the celebrations continue.

The end of the Euro?

Three interesting articles on what now seems to be considered an increasingly likely event -- the end of the Euro (in its current form, although some version might arise from the ashes).

First, Gavyn Davies speculates on several possible scenarios for the collapse of the Euro. It might persist as the new currency of a smaller union including Germany and The Netherlands (in which case the value of the Euro would rise significantly), or it might persist as the new currency of the periphery countries after Germany bolts (in which case the value of the Euro would fall significantly). Or the Europeans might finally find a way through the ongoing nightmare. Not betting on that one.

Second, Satyajit Das goes into a little more detail, and I think rightly sees some cultural issues as ultimately being most important. The three logical possibilities are easy to list:

The latest plan has bought time, though far less than generally assumed. The European debt endgame remains the same: fiscal union (greater integration of finances where Germany and the stronger economies subsidise the weaker economies); debt monetisation (the ECB prints money); or sovereign defaults. 

 Germany may be largely in favour of solution number 1. But the smaller periphery countries, and perhaps France as well, will favour solution number 2. Hence, we may by default find Europe hurtling inexorably into "solution" number 3 -- sovereign defaults:

The accepted view is that, in the final analysis, Germany will embrace fiscal integration or allow printing money. This assumes that a cost-benefit analysis indicate that this would be less costly than a disorderly break-up of the Euro-zone and an integrated European monetary system. This ignores a deep-seated German mistrust of modern finance as well as a strong belief in a hard currency and stable money. Based on their own history, Germans believe that this is essential to economic and social stability. It would be unsurprising to see Germany refuse the type of monetary accommodation and open-ended commitment necessary to resolve the crisis by either fiscal union or debt monetisation.

Unless restructuring of the Euro, fiscal union or debt monetisation can be considered, sovereign defaults may be the only option available.

Perhaps it betrays a little bit of anarchy in my own soul, but I'm rooting quite hard for sovereign defaults. I wish the Greeks had gone ahead with their referendum. For all the complaining about the slack morals of the Greek taxpayer, every debt-creating transaction has two sides -- and the creditors (French and German banks) bear as much responsibility as the debtors.

Then again, the end is likely to bring some severe social misery, not to mention riots (the UK is already advising its European embassies on the likelihood). A third article by Simon Johnson and Peter Boone points ominously in this direction, essentially echoing Davies' analysis in bleaker language:

The path of the euro zone is becoming clear. As conditions in Europe worsen, there will be fewer euro-denominated assets that investors can safely buy. Bank runs and large-scale capital flight out of Europe are likely.

Devaluation can help growth but the associated inflation hurts many people and the debt restructurings, if not handled properly, could be immensely disruptive. Some nations will need to leave the euro zone. There is no painless solution.

Ultimately, an integrated currency area may remain in Europe, albeit with fewer countries and more fiscal centralization. The Germans will force the weaker countries out of the euro area or, more likely, Germany and some others will leave the euro to form their own currency. The euro zone could be expanded again later, but only after much deeper political, economic and fiscal integration.

Tragedy awaits. European politicians are likely to stall until markets force a chaotic end upon them. Let’s hope they are planning quietly to keep disorder from turning into chaos.

The European debt crisis in a picture

From the New York Times (by way of Simon Johnson), a beautiful (and scary) picture of the various debt connections among European nations. (Best to right click and download and then open so you can easily zoom in and out as the picture is mighty big.)

My question is - what happens if the Euro does collapse? Do European nations have well-planned emergency measures to restore the Franc, Deutchmark, Lira and other European currencies quickly? Somehow I'm not feeling reassured.

The Greek crisis made clear...

This is far and away the most clear explanation I've seen of what is happening in Greece and why it poses an existential threat to the European Union. (h/t The Agonist)