The title of this piece is a bit provocative but what follows is not intended to be a hit piece on the field of economics, rather I am going to use two recent articles on economics’ failure as a jumping off point for thinking about this particular economic cycle and what macro analysis can offer in navigating it.
The overall thesis here is that, although the economics profession failed us during the housing bubble and its aftermath and although economics is an imprecise social science where uncertainty is a large factor, the profession has enough tools to be useful as a guide through and across business cycles. And this is not just true regarding micro-economic analysis but also regarding macro-economic analysis.
Before I go into why I believe this is so, let me outline the problems as put on display by two recent articles by economists. The first is by Noah Smith, an economics professor at Stony Brook University who writes in Bloomberg View on what happens when the economy baffles economists.
Noah writes:
It’s hard to overstate how few solid conclusions have emerged out of a century of macroeconomic research. We don’t even have a good grasp of what causes recessions..
[…]
Lucas’ progression roughly reflects the shifting fads in academia. In the 1970s, people mostly thought that recessions were caused by tight monetary policy. After the big inflation in the ’80s, people built models in which recessions happen because fewer new technologies got discovered in a given year. But that didn’t seem to explain the recessions induced by Federal Reserve Chairman Paul Volcker in the early 1980s, so new models were developed that attributed recessions, again, to tight monetary policy. After the financial crisis of 2008 and the deep recession that followed, macroeconomists shifted gears and started building models in which financial crises cause economic busts. The consensus shifts every time something big happens.
For those in the economics field arguing that economics is a science, this critique should offer some pause. But Noah also hits on something that is economics’ biggest problem in identifying why we see these ‘fads’ in the economics consensus.
The problem is data. Business cycles are few and far between. And business cycles that look similar to one another — the Great Depression and the Great Recession, for example — are even farther apart. It’s hard to tell whether policies have any effect, or whether those effects were about to happen anyway. The main statistical technique we have to analyze macro data — time-series econometrics — is notoriously inconclusive and unreliable, especially with so few data points. Comparing across countries helps a bit, but countries are all very different, and recessions can also spill over from one to another.
The uncomfortable truth is this: The reason we don’t really know why recessions happen, or how to fight them, is that we don’t have the tools to study them properly. This is the situation biologists were in when they were trying to fight disease before they had microscopes. Not only did they not have the right tools, they didn’t even have any way of knowing what the right tools would be!
So I can’t tell you when macroeconomics will have a real breakthrough.
This conclusion is discomforting for those who want to use economic analysis as a tool for managing their business or investments.
Stephen King, Chief Economist at HSBC takes a look specifically at monetary policy and also finds large deficits. The Economist magazine reports:
A new research paper by Stephen King, chief economist at HSBC, sees them more as unwitting villains than as Ms Lagarde’s unlikely heroes. His critique draws upon an interesting parallel: the breakdown of Keynesian demand-management in the inflationary crisis of the 1970s. That post-war approach, he argues, engendered too much certainty on the part of workers that the government would tolerate excessive wage claims for fear of high unemployment. While they gained, others especially pensioners and holders of bonds lost heavily. As wage-price spirals developed, policymakers failed to recognise that the problem was rooted in misjudged macroeconomic policies. Instead they sought to address it through incomes policies, which invariably fell apart.
The new framework that emerged in the wake of this failed approach featured above all independent, inflation-targeting central banks. Mr King argues that this single-minded approach also contained the seeds of its destruction, for it engendered a new certainty, celebrated in the “great moderation” of both price and output stability before the crisis, for which Ms Lagarde’s heroes modestly took a bow. This time the groups that gained were investors and creditors, for the narrow focus on attaining price stability meant that central banks kept interest rates low even as markets became frothy. They wrongly argued that it was better to mop up after a bubble had burst than to take pre-emptive action, and claimed that in any case it was very difficult to discern a bubble until after the event.
And as we know, it was this ‘policy fad’ that led to the global credit and housing bubble that popped disastrously in 2007 and caused an economic and financial crisis of epic proportions. Arguably, that crisis is still not over.
So looking at these two analyses, it seems like both macroeconomics and its application are abject failures with no hope on the horizon. I am not pessimistic, however, in large part because I believe mainstream economics failed because it has yet to incorporate a sufficient diversity of thought that already exists into macro-analysis and policy prescriptions.
Think of Minsky’s instability hypothesis for example.
Right now, the froth in markets is becoming extreme. I saw at least five cases of reduced volatility and increased risk just perusing the headlines this morning. In one headline at the Telegraph, demand for risky mortgages reaches a five-year high in Britain. In another Telegraph headline, we are advised “why 6pc income from ‘peer-to-peer’ can replace annuities.” At Bloomberg, we learn that Spanish 10-year yields have dropped below Treasuries. While at Reuters we learn that the country formerly known as “the next Cyprus”, Slovenia, is borrowing for 10 years at 3% yields. Meanwhile loss-making GoDaddy is set for an IPO using adjusted EBITDA statistics to mask its lack of profitability. It will probably be a successful IPO.
Everyone is talking about the reduction in volatility. And this time around, because of what we experienced as the Great Moderation reached an apogee in 2007 and 2008, we are more concerned that low volatility equals untoward levels of risk. Some people have learned that stability breeds instability, just as Minsky had been saying since at least the 1970s. Isn’t that progress?
Here’s the question: what do we do with the orthodox and heterodox lessons we individually have learned? Just because Minsky was not a mainstream economist whose instability hypothesis does not lend itself well to econometric analysis does not mean we can’t use his insight. Jeremy Grantham, for example, has been doing macro market analysis of a similar vein that tells him that markets are overvalued. As a value investor, that means he has to reduce risk. This is exactly what Minsky’s hypothesis would tell you to do i.e. reduce risk as others increase it because risk-taking is mean-reverting within one business cycle.
From a macro policy perspective, there are all sorts of policy prescriptions one could take. Think of Amir Sufi and Atif Mian’s ideas on risk-sharing debt contracts. This concept is clearly meant to create counter-cyclical buffering to prevent the inherent pro-cyclicality of risk assessment from causing business cycles to go into severe boom and bust phases. I have developed a theory of enhanced fiscal stabilizers of a similar vein i.e. changes in payroll taxes and unemployment insurance that are automatically adjusted according to changes in jobless claims, the unemployment rate, GDP growth and inflation or other economic metrics. The goal is to have fiscal policy be countercyclical at both peak and trough in a way that is not political or requires politicized decision-making. This is very much a Minsky-friendly framework.
The bottom line here? There are plenty of macro-economic guideposts we can use to help us perform better as investors, manage our business to the business cycle and make informed policy prescriptions. In my view, the problem is not the failure of economics. Rather, the problem is the psychology of change. Human beings are programmed to resist change. And the degree to which they accept change, they do so by overthrowing one orthodoxy with another. The vast majority of us are risk-averse enough that we are not going to deviate from that orthodoxy no matter how inviting a heterodox approach is. Missing a bull market is a dismissible offense. That leaves plenty of opportunity then for you as an individual to understand that business cycles are endemic to capitalism because stability leads to optimism and increased risk taking which eventually leads to poor risk management, unexpected losses, and a retrenchment into excessive risk aversion. This is human psychology and it is not going to change. But the tools to understand it and how it affects the economy are there.