Over at Project Syndicate: What Failed in 2008?

Over at Project Syndicate:

For a while the best book on the macroeconomic catastrophe that struck the North Atlantic starting in 2007 was Gary Gorton’s Slapped by the Invisible Hand. Them for a while the best book was Alan Blinder’s After the Music Stopped. Now these have been superseded by two: the extremely-observant sensible Tory Martin Wolf’s The Shifts and the Shocks; and my friend, patron, teacher, and (until the last reshuffle) office neighbor Barry Eichengreen ‘s Hall of Mirrors. Read and grasp the messages of both of these, and you are in the top 0.001% of the world in terms of understanding what has happened to us–and what the likely scenarios are for what comes next.

Consider, first, Martin Wolf’s The Shifts and the Shocks. Its spine is a masterful cataloguing of all the major shifts we have seen that set the stage for the disaster that hit the North Atlantic in 2007-9:

1. The huge rise in the wealth of the global 0.01% and 0.1%, with its consequent pressures for overleverage and demand volatility
2. The global savings glut, with more of the same pressures.
3. The “insouciance” toward the resulting risks generated by the intellectual victory of the rational-expectations and efficient-markets hypotheses.
4. The resulting deregulation, that made it easy to sell assets perceived to be safe that were not in fact so and to greatly multiply the systemic risk in the system beyond any central banker’s imagining.
5. The resulting policy-making climate, with the three-fold hubris of: (1) underestimating tail risks, (2) settling on a 2%/year inflation target that did not provide sufficient systemic risk sea-room, and (3) the greater hubris of the creation of the euro.
6. The continuation in which it apparently made sense in 2008 and since to do what was necessary but no more than necessary to handle the immediate crisis

In the context of these shifts, Martin Wolf sees immediate need in the short-run for policies to solve the immediate crisis: more spending, especially investment spending, by reserve-currency issuing sovereigns; more issue of high-quality debt to resolve the safe asset shortage by reserve-currency issuing sovereigns; and reserve-currency issuing central banks that monetize enough of this debt to raise the trend inflation rate from 2%/year to 3%/year or 4%/year. The argument seems, to me at least, to be convincing and unassailable.

But that is not all. Wolf’s book calls as well for medium run policies: (1) Either “break up… or… create a minimum set of institutions and policies” to make the euro work. And (2) the obvious but undone regulatory measures to greatly diminish leverage and the use of debt. And last come Wolf’s recommendations for the long-run: policies for more equal wealth; better economics less in thrall to rational-expectations and efficient-market ideologues; “more global regulation… and more freedom for individual countries to craft their own responses”. These seem to me to be obvious requirements on the situation.

But 2005-2014 did not create the pressures to do what Wolf and I see as the obvious things. Why not? And here is where Eichengreen’s Hall of Mirrors is most useful.

It tells the story of a historical process with five stages. The first is the intellectual victory within sensible economics of monetarist over old Keynesian and Minskyite interpretations of the Great Depression. The second is the resulting ability and willingness of governments to pull the monetarist policy package–what Milton Friedman had promised would have stopped the Great Depression in its tracks and erased its effects–off of the shelf and apply it in 2008-2009. The third is the very incomplete but also very real partial effectiveness of that package, for the monetarist interpretation of the Great Depression was, to put it baldy, wrong and radically incomplete. But it did enough good that a full-fledged repetition of the Great Depression was avoided.

And that led to the fourth stage: the declaration by governments of victory–of green shoots–of the successful resolution of a crisis–of a need to turn policies toward more important “structural” issues involving the necessity for “austerity” in the size of government. This fourth stage has been followed by the fifth in which we are now embedded: First, a very partial barely-a-recovery, one that is turning into a new normal in which the North Atlantic will turn out to have thrown away a full ten percent of all of what was its potential future wealth. Second, the failure to undertake the financial regulatory and economic governance reforms needed to diminish the chances of a repeat of the disaster in which we are still embedded.

Thus, Eichengreen concludes, partial success turns out to be global failure: immediate pain of a proportional magnitude equal to that of the Great Depression was avoided, but the potential for economic growth and successful macroeconomic stabilization in the North Atlantic going forward will be (because of failure to learn the lessons of 2000-2010 and make the obvious reforms) less post-2015 than it was post-1945, back when the lessons of 1925-1935 had been learned and the obvious reforms had been made.

Wolf sets out what we ought to have done. Eichengreen provides the narrative of the historical process which has led us not to do it.

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