There are two really good reasons for the GEM Blog’s obsession with mainstream New Keynesian theorists’ take on how to prevent Great Recessions. First, the issue is extraordinarily important. The 2008-09 crisis generated costs of many trillions of dollars. Effective stabilization policy is by far the most crucial problem on which modern economists can work. Second, the academy’s consensus approach to GR prevention is simply wrong, an assessment more harshly asserted by stabilization authorities. What most disturbs me is that macro theorists must know better; they are choosing to be wrong. That choice has become an existential crisis for the New Keynesian mainstream. Despite the stark lessons of the past decade, consensus thinking continues to recklessly gamble profession’s credibility on a policy design that, while consistent with what is taught to graduate students, doesn’t come close to either explaining or preventing Great Recessions.
Bad policy. The argument needs illustration. Olivier Blanchard’s Munich lecture, “The Crisis: Basic Mechanisms, and Appropriate Policies” (November 18, 2008), will represent mainstream thinking. He begins his real-time analysis by asking the right question: How did the U.S. subprime mortgage crisis, a relatively small phenomenon, produce multi-trillion-dollar losses. His answer, divided into four parts, is less successful. First is an identification the crisis initial initial conditions, featuring the development of a class of subprime securities the opacity of which encouraged underestimation of their true risks. He then adds the underappreciation of financial-system connectiveness and high leverage. Second, “by identifying the two ampliﬁcation mechanisms behind the crisis, once the trigger had been pulled and some of the assets appeared bad or doubtful. I see two related, but distinct, mechanisms: ﬁrst, the sale of assets to satisfy liquidity runs by investors; and, second, mechanisms can lead, and indeed have led, to very large eﬀects of a small trigger on world economic activity.”
Third, “showing how the ampliﬁcation mechanisms have played out in real time, moving from subprime to other assets, from institutions to institutions, and from the United States, ﬁrst to Europe, and then to emerging countries.” And, fourth, “current policies should be aimed at limiting the two ampliﬁcation mechanisms at work at this juncture. Future regulation and policies should also aim however at avoiding a repeat of some of those initial conditions.”
In a nutshell, Blanchard’s mainstream policy to prevent future GRs is to prevent the class of macro-shocks implicated in the 2008-09 crisis. If a powerful financial failure has already occurred, policies “should be aimed at limiting the two ampliﬁcation mechanisms”. That’s it. Mainstream macroeconomists have designed a set of reforms designed to prevent a particular kind of banking crisis. No familiar banking shocks, no Great Recession with its multi-trillion-dollar costs. The kindest assessment of their approach is that it is doomed to failure. That outcome is partly rooted in the fact that future macro shocks will most likely occur outside the large banks that are the target of the mainstream policy proposals. The so-called shadow-banking system, greatly exceeding its federally-regulated banking counterpart in size, was created largely to avoid federal-banking regulation. It has proved to be too nimble to have its risk appetite effectively curbed by codifying tighter restrictions on business lines and capital. Knowing that the task is beyond their capability, regulatory authorities don’t much try.
This argument could also use illustration. I was at the table when the Governors of the Federal Reserve debated, years before the 2008-09 extreme instability, the substantial fraud occurring in the underwriting of subprime residential mortgages. The dangerous behavior was known to be occurring outside the federally regulated banking system. Numerous tiny state-regulated mortgage brokers were pumping out fraudulent subprime paper. While their truth-in-lending authority gave them regulatory power to intervene, Fed Governors recognized the miscreants would simply close and pop up elsewhere. They were classic examples of nimble shadow-banking operations effectively designed to avoid effective oversight.
Moreover, not all market failure of a size capable of setting-off broad propagations that are characteristic of GRs are financial in nature. Macro shocks demonstrate great variety. Such disturbances are intrinsic to modern, highly specialized economies and, as a practical matter, cannot be prevented. David Romer (2014) shows that even the subgroup of financial shocks are commonplace and heterogeneous. He identifies six such major crises in the past three decades. The lesson of history and logic is two-fold. Preventing all powerful macro shocks is a fool’s errand, and not all such disturbances produce Great Recessions.
What about Blanchard’s policies to prevent amplification of macro shocks that do occur? He must know that his back-up policy class is inadequate. Failure is assured by the amazing fact that he ignores the most powerful propagation mechanism: changes in total nominal spending. Almost all of the multi-trillion-dollar cost of the Great Recession resulted from collapsing aggregate demand that accompanied the collapse in subprime security prices, not the financial-market failure itself. Mainstream theorists worth their salt know that, so why don’t their policy recommendations include strengthening stabilization authorities’ capacity to halt and reverse contractions in demand?
The answer is that mainstream general-market-equilibrium macroeconomics cannot accommodate a causal link from nominal demand disturbances to involuntary job loss and recognizably-sized movement in employment, output, and income. It is deeply embarrassing that the macro academy has chosen to prioritize defending its own human capital and reputations, providing policy advice that they know will be ineffective.
Good policy. Mainstream theorists lack adequate macroeconomics. It is good news then that the GEM Project has solved the existential problem. It has constructed a general-equilibrium model rooted in rational price-mediated exchange that supports a policy class capable of preventing GRs. The GEM focus is, as a successful approach must be, on halting and reversing collapsing total demand propagating macro shocks.
The Project’s demand-side modeling, considered in more detail last week, is motivated by three interrelated ideas. The first is rooted in work by Stokey (2009). Once investors/lenders become uncertain about future macro trends, especially the adequacy of total demand, they reasonably become more inactive, postponing acquisition of assets until the uncertainty dissipates. Second is the bedrock GEM nominal-to-real causality that powerfully propagates macro shocks. The third roots investor/lender macro uncertainty in the loss of credibility of stabilization authorities’ trend real-side objective. That credibility, denoted by Ƈ throughout the Project, is increasing in the degree to which the future state of the macroeconomy is believed to be consistent with stabilization authorities’ objectives. (Chapter 6) The fundamental message is: The generalization of rational exchange from the marketplace to the highly specialized workplace provides the bedrock analysis necessary for the construction of policies that will effectively prevent future Great Recessions.
Blog Type: New Keynesians Chicago, Illinois