Hoisted from the 2007 Archives: Clueless Brad DeLong Was Clueless: Central Banking and the Great Moderation

Hoisted from the 2007 Archives: Wow! I had no clue in mid-2007 what was about to come down.

I had no idea of how the money-center universal banks had exposed themselves to housing derivatives, how strongly the right-wing noise machine would lobby against the Federal Reserve’s undertaking its proper lender-of-last-resort job, or how hesitant and ineffective the Federal Reserve would turn out to be in the summer and fall of 2008:

Central Banking and the Great Moderation http://www.bradford-delong.com/2007/07/central-banking.html: http://www.businessday.co.za/articles/topstories.aspx?ID=BD4A507305 IT HAS been 20 years since Alan Greenspan became chairman of the US Federal Reserve. The years since then have seen the fastest global average income growth rate of any generation, as well as remarkably few outbreaks of mass unemployment-causing deflation or wealth-destroying inflation. Only Japan’s lost decade-and-a-half and the hardships of the transition from communism count as true macroeconomic catastrophes of a magnitude that was depressingly common in earlier decades. This “great moderation” was not anticipated when Greenspan took office.

US fiscal policy was then thoroughly deranged — much more so than it is now. India appeared mired in stagnation. China was growing, but median living standards were not clearly in excess of those of China’s so-called “golden years” of the early 1950s, after land redistribution and before forced collectivisation turned the peasantry into serfs. European unemployment had just taken another large upward leap, and the “socialist” countries were so incompatible with rational economic development that their political systems would collapse within two years. Latin America was stuck in its own lost decade after the debt crisis at the start of the 1980s.

Of course, the years since 1987 have not been without big macroeconomic shocks. America’s stock market plummeted for technical reasons that year. Saddam Hussein’s invasion of Kuwait in 1991 shocked the world oil market. Europe’s fixed exchange rate mechanism collapsed in 1992. The rest of the decade was punctuated by the Mexican peso crisis of 1994, the east Asian crisis of 1997-98, and troubles in Brazil, Turkey, and elsewhere, and the new millennium began with the collapse of the dotcom bubble in 2000 and the economic fallout from the terrorist attacks of September 11 2001.

So far, none of these events — aside from Japan starting in the early 1990s and the failures of transition in the lands east of Poland — has caused a prolonged crisis. Economists have proposed three explanations for why macroeconomic catastrophes have not caused more human suffering over the past generation. First, some economists argue that we have just been lucky, because there has been no structural change that has made the world economy more resilient.

Second, central bankers have finally learned how to do their jobs. Before 1985, according to this theory, central bankers switched their objectives from year to year. One year, they might seek to control inflation, but the previous year they sought to reduce unemployment, and next year they might try to lower the government’s debt refinancing costs, and the year after that they might worry about keeping the exchange rate at whatever value their political masters preferred.

The lack of far-sighted decision-making on the part of central bankers meant that economic policy lurched from stop to go; to accelerate to slow down. When added to the normal shocks that afflict the world economy, this source of destabilising volatility created the unstable world before 1987 that led many to wonder why somebody like Greenspan would want the job.

The final explanation is that financial markets have calmed down. Today, the smart money in financial markets takes a long-term view that asset prices are for the most part rational expectations of discounted future fundamental values. Before 1985, by contrast, financial markets were overwhelmingly dominated by the herd behaviour of short-term traders, people who sought not to identify fundamentals, but to predict what average opinion would expect average opinion to be, and to predict it before average opinion did.

When I examine these issues, I see no evidence in favour of the first theory. Our luck has not been good since 1985. On the contrary, I think our luck — measured by the magnitude of the private sector and other shocks that have hit the global economy — has, in fact, been relatively bad. Nor do I see any evidence at all in favour of the third explanation. It would be nice if our financial markets were more rational than those of previous generations. But I don’t see any institutional changes that have made them so.

So my guess is that we would be well-advised to put our money on the theory that our central bankers today are more skilled, more far-sighted, and less prone to either short-sightedly jerking themselves around or being jerked around by political masters who unpredictably change the objectives they are supposed to pursue year after year. Long may this state of affairs continue.

And Felix Salmon had little clue either:

Felix Salmon (2007): Subprime Mess: It’s Not Derivatives’ Fault: “I’m sure it’s been happening a lot in idle conversation… http://www.bradford-delong.com/2007/07/subprime-mess-i.html

…but it’s still disheartening to see it happening in on the front page of a WSJ section: confusing illiquidity problems in the subprime market with more theoretical worries about derivatives…. Scott Patterson… should know better, in his Ahead of the Tape column….

There is no indication whatsoever here that Patterson understands that the illiquid securities which are causing so much trouble in the “subprime-mortgage crackup” aren’t derivatives…. CDOs are securities–not derivatives–which are very, very rarely traded. As a result, they’re often “marked to model” rather than being marked to market. That seems to be the problem that Patterson’s column is concerned about, and it’s silly for him to be complaining about derivatives in this regard.

It’s true that the troubled Bear Stearns funds did invest in some derivatives–mainly bets on the direction of the ABX.HE index of subprime bonds. Those investments rose and fell in value very transparently, and were by far the easiest part of the Bear portfolio to unwind. So let’s not start blaming illiquid derivatives for Bear Stearns’ problems. Right now, illiquid derivatives are the least of anybody’s problems…