Why economists failed to anticipate the financial crisis

About three months ago, Nobel Prize winning economist Paul Krugman took a stab at explaining why economists didn’t anticipate the worst financial crisis in three-quarters of a century. His was a long piece, taking up eight pages and 6,000 words at the New York Times website. His overview was certainly one of the best in explaining the running debates over stimulus and government intervention that have been raging for over two decades between economists of the Saltwater variety (i.e. from schools near the coasts) and those of the Freshwater variety (i.e. from the University of Chicago).  And for this reason alone, it should not be forgotten.

Crucially, Krugman said:

During a normal recession, the Fed responds by buying Treasury bills — short-term government debt — from banks. This drives interest rates on government debt down; investors seeking a higher rate of return move into other assets, driving other interest rates down as well; and normally these lower interest rates eventually lead to an economic bounceback. The Fed dealt with the recession that began in 1990 by driving short-term interest rates from 9 percent down to 3 percent. It dealt with the recession that began in 2001 by driving rates from 6.5 percent to 1 percent. And it tried to deal with the current recession by driving rates down from 5.25 percent to zero.

But zero, it turned out, isn’t low enough to end this recession. And the Fed can’t push rates below zero, since at near-zero rates investors simply hoard cash rather than lending it out. So by late 2008, with interest rates basically at what macroeconomists call the “zero lower bound” even as the recession continued to deepen, conventional monetary policy had lost all traction.

Now what?

Paul Krugman is a Keynesian. So, his prescription is fiscal stimulus. Have the government pump money into the economy and it will alleviate some of the pressure for the private sector. There is some merit to this argument on stimulus. Many Freshwater economists say monetary stimulus is what is needed. If the Federal Reserve increases the supply of money, eventually the economy will respond. This is what Ben Bernanke was saying in his famous 2002 Helicopter speech at the National Economists Club.

Yet, I couldn’t help but notice that Krugman mentioned the word debt only twice in 6,000 words. In fact, it is in the very passage above where Krugman uses the term for the only time in the entire article. And here Krugman refers to government debt; no mention of private sector debt whatsoever.  I have a problem with that.

Let me fill in some of the pieces. In the run-up to the Holiday Season, I missed a good article by Derek Scott in last week’s Financial Times. Scott explains very lucidly why economists failed to anticipate the financial crisis. He starts out:

The current crisis reflects not the failure of capitalism, but the failure of the people running capitalism to understand how it works. This is bound to affect how we get out of the mess.

In simple terms, the prevailing consensus is to view the post-2007 crisis as the result of an external shock which could not have been anticipated. The remedy is to deal with the perceived cause (bankers or regulators) embarking on large-scale fiscal and monetary stimuli until the damaged “animal spirits” of households and business are restored. After this, things can get back to normal and stimuli be withdrawn.

I hope you recognize this argument because it is identical to the Keynesian and Monetarist arguments from Bernanke and Krugman above. But this misses the problem with debt caused in large part by artificially low interest rates.  Scott explains:

A series of monetary policy mistakes in the late 1990s meant that interest rates were too low, creating in several countries what Austrian economists such as Friedrich Hayek, called an “inter-temporal” problem. It is no coincidence that economists who did predict the crisis, notably in Britain the estimable Bernard Connolly, looked at economics in a similar way.

In essence what happens is that inappropriately low rates of interest bring forward investment spending by households and business (adding to demand when it takes place) from “tomorrow” to “today” so that when “tomorrow” arrives, budget constraints reduce spending at precisely the time when “yesterday’s” investment comes on stream, adding to supply. The only way to keep things going is even lower interest rates, bringing forward even more spending, so establishing the international Ponzi game that eventually burst in 2007.

This economic Ponzi scheme is what I have labeled the asset-based economy. As with all things Ponzi, it must come to a spectacularly bad end. One can only Inflate asset prices to perpetuate a debt-fuelled consumption binge so far. At some point, the Ponzi scheme collapses. And we are nearing that point.  We still have zero rates, massive amounts of liquidity, manipulation of short-term rates, manipulation of long-term rates, and bailouts galore a full 15 months after Lehman Brothers collapsed. This is pure insanity.

The reason economists failed to anticipate the crisis is because they were fixated on avoiding downturns and driving the economy to unsustainable growth rates by using debt to consume today what will be earned in the future. Debt is the central problem. When debt to income or debt to GDP doubles, triples and quadruples, it says you have doubled, tripled and quadrupled the amount of future earnings you are consuming in the present (see the charts here and here). That necessarily means you will have less to spend in the future. It’s not rocket science.

And let’s not forget that artificially low interest rates distort capital and investment allocation so that many of the so-called economic gains turn out to be illusory.

So, Mr. Krugman asks now what?

Now that we finally recognize that we are overindebted, I say we should move cautiously in a direction of less consumption, more savings and less debt – the key word being caution.

Update: if you want a more graphic and risqué version of this idea see How did economists get it so wrong (parody version)? (not a ‘work-friendly’ video, if you know what I mean).



Insight: More capitalism, less regulation – Derek Scott, FT

How Did Economists Get It So Wrong? – Paul Krugman, NY Times

Deflation: Making Sure "It" Doesn’t Happen Here – Ben Bernanke, Federal Reserve Board

  1. LavrentiBeria says

    Paul Krugman, it is said, uniquely distinguished for have predicted all eight of the recessions occuring since 2003.

  2. Mark Wadsworth says

    The Land Value Taxers saw this recession coming a mile off. House price bubbles are just symptoms of credit bubbles and they always burst.

    As to your last bit “less consumption, more savings and less debt” that was the problem – all the money was going on the housing Ponzi scheme. Don’t forget that one man’s consumption is another man’s production – and I don’t think that we have been ‘over-producing’ in the last ten years.

  3. Wag the Dog says

    Then there is Prof. Steve Keen’s view: Neo-classical economics is just plain dangerous.

    His most recent post-Keynesian perspective on what will likely happen going forward in given at the end of his New Year’s blog posting.

  4. Anonymous says

    Does anybody have a link to a site that shows the history of Japanese debt to gdp at the household/business/government levels? I’ve been trying to find one the graphically depicts what has happened in Japan but have not found what I’m looking for.

    After reading Barron’s interview with Koo, I do not sense any real belief in a positive outcome. It is pretty clear we are in the early stages of a massive experiment.

    1. Wag the Dog says

      I found one that breaks down into Govt/Private debt to GDP for Japan.

  5. demandside says

    This is the crux of the matter.

    Two objections:

    (1) the increase in debt was Ponzi debt, or speculative debt, that is, debt that could not be serviced by the output of the asset that was bought. MacMansions, securities based on MacMansions. Debt that creates its stream of earnings, such as can be got very easily in the energy and conservation arena with a higher (real world) carbon price, is not debt that should be avoided. This is productive debt. And there are other examples.

    (2) Less consumption of private consumer goods, yes. But to expect this mountain of debt to go away by just hunkering down is wrong. Capitalism has the peculiar need for investment. But the more critical point is that the mountain of debt has to be attacked directly, by writing it down and letting the creditors share the poverty. There is no recovery in a share-cropper economy.

    1. Edward Harrison says

      Hunkering down is certainly not going to get it done. You and I agree about writedowns. That is the reason this blog is named as such. You have to write this debt down and move on. If that means bankruptcy and liquidation for some financial entities, then so be it. get on with it by trying as best as possible to firewall the rest of the system from contagion. This is what FDIC bank seizures are about.

      This is also what mortgage modifications are about. The McMansions you point to were about consumption, not investment. Now that prices have stopped galloping ahead, this is more readily apparent.

      1. demandside says

        point taken

  6. Onlooker from Troy says

    Well said, Edward. The vast majority of economists and economic theory is so terribly wrong and wrongheaded, it’s a tragedy.

    They enabled the blowing up of this huge and disastrous debt bubble through their enabling of politicians’ greedy and irresponsible spending and their trampling of common sense in the general populace.

    Many people knew, without having economic degrees, that it was unsustainable and foolish, but they were derided as uneducated, unsophisticated rubes who “just didn’t get it.” And many just threw in the towel and joined the debt orgy, making it all that much worse. And of course the thieves and con artists on Wall Street and elsewhere in the financial sector just licked their chops as they were given full rein to fleece the world.

    These dangerous academics, like Krugman, need to be soundly discredited before causing more damage. Alas I don’t think we’ll get there without a huge damaging washout of our economy when the debt house of cards finally collapses from it’s own weight and instability. Ponzi indeed.

    Now how about SS and Medicare? Ugh.

  7. Anonymous says

    Economists could not foresee the financial crisis because they do not have their own independent minds. Most of them are under the obligations of capitalist clas whether it for their reseach projects or their own jobs. Noble Laureate Paul Samuelson has used the word ‘kept men’ for some economists who toe the lines of their paymasters directly or indirectly. He says,”Although the thought would spoil digestions at a downtown eating clubs, the economist has always played the role of interpreter to the academic community of the businessmen and of material activity generally. What do we expect from the ‘obliged’ economists of getting some signals about worse conditions the capitalist class would face in near future?
    Same economists have been spreading disinformation about ‘free market’ in deveoped countries like the USA. There is no free market any where in the world. What we see is monopoly and oligopoly markets. This allows to amass the wealth and profits. If free market system is practiced in real terms as defined in any textbook on economics, the capitalist system would just collapse.
    Maximum number of Noble Laureates economists are residing in the USA. Why none of them could dare to announce the impending depression and economic crisis? Reason is simple as given above.

  8. fresnodan says

    “n simple terms, the prevailing consensus is to view the post-2007 crisis as the result of an external shock …”
    Uh, did the Martians invade??? Did Dinosaurs come from out of the center of the earth, trampling crops, eating people, and reign havoc???
    Did people from the future come back in time and bid up real estate values, because in 3000 years current prices are a “bargain???”
    I have never heard a definition of “external” with regard to economics that is cogent, coherent, and logical.

  9. Stevie b. says

    “We still have zero rates, massive amounts of liquidity, manipulation of short-term rates, manipulation of long-term rates, and bailouts galore a full 15 months after Lehman Brothers collapsed. This is pure insanity.”

    Ed – I have a feeling that you and I thought things were already insane 15 months ago. All we’ve done is swap one bout of insanity with another in typical (and not unanticipated) muddle-through denial of the decline of the developed economies over the last 20-odd years.

    Despite many possible complications (not excluding Iran), expect more of the same sort of stuff (despite talk of exit strategies, and not excluding negative interest rates or even more esoteric, as-yet undreamt-of fun & games) until the desperately hoped-for arrival of a knight on a white charger – perhaps powered by ubiquitously cheap solar cells!

    P.S. reading your comments here, I guess it doesn’t take a genius to see how you might/might not be voting on your poll!

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