Clueless DeLong Was Clueless About What Was Coming in 2007 and 2008: Hoisted from the Archives

From November 2008: Why I Was Wrong… Calculated Risk issues an invitation:

Calculated Risk: Hoocoodanode?: Earlier today, I saw Greg “Bush economist” Mankiw was a little touchy about a Krugman blog comment. My reaction was that Mankiw has some explaining to do. A key embarrassment for the economics profession in general, and Bush economists Greg Mankiw and Eddie Lazear in particular, is how they missed the biggest economic story of our times…. This was a typical response from the right (this is from a post by Professor Arnold Kling) in August 2006:

Apparently, the echo chamber of left-wing macro pundits has pronounced a recession to be imminent. For example, Nouriel Roubini writes, “Given the recent flow of dismal economic indicators, I now believe that the odds of a U.S. recession by year end have increased from 50% to 70%.” For these pundits, the most dismal indicator is that we have a Republican Administration. They have been gloomy for six years now…

Sure Roubini was early (I thought so at the time), but show me someone who has been more right! And this brings me to Krugman’s column: Lest We Forget

Why did so many observers dismiss the obvious signs of a housing bubble, even though the 1990s dot-com bubble was fresh in our memories? Why did so many people insist that our financial system was “resilient,” as Alan Greenspan put it, when in 1998 the collapse of a single hedge fund, Long-Term Capital Management, temporarily paralyzed credit markets around the world? Why did almost everyone believe in the omnipotence of the Federal Reserve when its counterpart, the Bank of Japan, spent a decade trying and failing to jump-start a stalled economy?

One answer to these questions is that nobody likes a party pooper…. There’s also another reason the economic policy establishment failed to see the current crisis coming. The crises of the 1990s and the early years of this decade should have been seen as dire omens, as intimations of still worse troubles to come. But everyone was too busy celebrating our success in getting through those crises to notice…

[I]n addition to looking forward, I think certain economists need to do some serious soul searching. Instead of leaving it to us to guess why their analysis was so flawed, I believe the time has come for Mankiw, Kling, and many other economists to write a post titled “Why I was wrong”…

And I respond:

Let me say what things I was “expecting,” in the sense of anticipating that it was they were both likely enough and serious enough that public policymakers should be paying significant attention to guarding the risks that it would create:

(1) A collapse of the dollar produced by a panic flight by investors who recognized the long-term consequences of the U.S. trade deficit.


(2) A fall back of housing prices halfway from their peak to pre-2000 normal price-rental ratios.

I was not expecting (2) plus:

(3) the discovery that banks and mortgage companies had made no provision for how the loans they made would be renegotiated or serviced in the event of a housing-price downturn.

(4) the discovery that the rating agencies had failed in their assessment of lower-tail risk to make the standard analytical judgment: that when things get really bad all correlations go to one.

(5) the fact that highly-leveraged banks working on the originate-and-distribute model of mortgage securitization had originated but had not distributed: that they had, collectively, held on to much too much of the risks that they were supposed to find other people to handle—selling the systemic risk they had created, but not all of it, and buying the systemic risk that their peers had created.

(6) the panic flight from all risky assets–not just mortgages–upon the discovery of the problems in the mortgage market.

(7) the engagement in regulatory arbitrage which had left major banks even more highly leveraged than I had thought possible.

(8) the failure of highly-leveraged financial institutions to have backup plans for recapitalization in place in the case of a major financial crisis.

(9) the Bush administration’s (and the Federal Reserve’s!) sticking to a private-sector solution for the crisis for months after it had become clear that such a solution was no longer viable.

We could have interrupted this chain that has gotten us here at any of a number of places. And I still am trying to figure out why we did not.

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 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…

…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…

Misdiagnosis of 2008 and the Fed: Inflation Targeting Was Not the Problem. An Unwillingness to Vaporize Asset Values Was Not the Problem…

This, from the very sharp Martin Wolf, seems to me to go substantially awry when Martin writes the word “convincingly”. Targeting inflation is not easy: you don’t see what the effects of today’s policies are on inflation until two years or more have passed. Targeting asset prices, by contrast, is very easy indeed: you buy and sell assets until their prices are what you want them to be.

As I have said before, as of that date January 28, 2004, at which Mallaby claims that Greenspan knew that he ought to “vaporise citizens’ savings by forcing down [housing] asset prices” but had “a reluctance to act forcefully”, that was not Greenspan’s thinking at all. Greenspan’s thinking, in increasing order of importance, was:

  1. Least important: that he would take political heat if the Fed tried to get in the way of or even warned about willing borrowers and willing lenders contracting to buy houses and to take out and issue mortgages.

  2. Less important: a Randite belief that it was not the Federal Reserve’s business to protect rich investors from the consequences of their own imprudent folly.

  3. Somewhat important: a lack of confidence that housing prices were, in fact, about fundamentals except in small and isolated markets.

  4. Of overwhelming importance: a belief that the Federal Reserve had the power and the tools to build firewalls to keep whatever disorder finance threw up from having serious consequences for the real economy of demand, production, and employment.

(1) would not have kept Greenspan from acting had the other more important considerations weighed in the other direction: Greenspan was no coward. William McChesney Martin had laid down the marker that: “If the System should lose its independence in the process of fighting for sound money, that would indeed be a great feather in its cap and ultimately its success would be great…” Preserving your independence by preemptively sacrificing it when it needed to be exercised was not Greenspan’s business. (2) was, I think, an error–but not a major one. And on (3), Greenspan was not wrong:

S P Case Shiller 20 City Composite Home Price Index© FRED St Louis Fed

Nationwide, housing prices today are 25% higher than they were at the start of 2004. There is no fundamental yardstick according to which housing values then needed to be “vaporized”. The housing bubble was an issue for 2005-6, not as of the start of 2004.

It was (4) that was the misjudgment. And the misjudgment was not that the economy could not handle the adjustment that would follow from the return of housing values from a stratospheric bubble to fundamentals. The economy handled that return fine: from late 2005 into 2008 housing construction slackened, but exports and business investment picked up the slack, and full employment was maintained:

Macroeconomic Overview Talk for UMKC MBA Students April 1 2013 DeLong Long Form

The problem was not that the economy could not climb down from a situation of irrationally exuberant and elevated asset prices without a major recession. The problem lay in the fact that the major money center banks were using derivatives not to lay subprime mortgage risk off onto the broad risk bearing capacity of the market, but rather to concentrate it in their own highly leveraged balance sheets. The fatal misjudgment on Greenspan’s part was his belief that because the high executives at money center banks had every financial incentive to understand their derivatives books that they in fact understood their derivatives books.

As Axel Weber remarked, afterwards:

I asked the typical macro question: who are the twenty biggest suppliers of securitization products, and who are the twenty biggest buyers. I got a paper, and they were both the same set of institutions…. The industry was not aware at the time that while its treasury department was reporting that it bought all these products its credit department was reporting that it had sold off all the risk because they had securitized them…

That elite money center financial vulnerability and the 2008 collapse of that Wall Street house of cards, not the unwinding of the housing bubble, was what produced the late 2008-2009 catastrophe:

Macroeconomic Overview Talk for UMKC MBA Students April 1 2013 DeLong Long Form

Greenspan’s error was not in targeting inflation (except at what in retrospect appears to be too low a level). Greenspan’s error was not in failing to anticipatorily vaporize asset values (though more talk warning potentially overleveraged homeowners of risks would have been a great mitzvah for them). Greenspan’s error was in failing to regulate and supervise.

Martin Wolf: Man in the Dock:

Of his time as Fed chairman, Mr Mallaby argues convincingly that:

The tragedy of Greenspan’s tenure is that he did not pursue his fear of finance far enough: he decided that targeting inflation was seductively easy, whereas targeting asset prices was hard; he did not like to confront the climate of opinion, which was willing to grant that central banks had a duty to fight inflation, but not that they should vaporise citizens’ savings by forcing down asset prices. It was a tragedy that grew out of the mix of qualities that had defined Greenspan throughout his public life—intellectual honesty on the one hand, a reluctance to act forcefully on the other.

Many will contrast Mr Greenspan’s malleability with the obduracy of his predecessor, Paul Volcker, who crushed inflation in the 1980s. Mr Greenspan lacked Mr Volcker’s moral courage. Yet one of the reasons why Mr Greenspan became Fed chairman was that the Reagan administration wanted to get rid of Mr Volcker, who “continued to believe that the alleged advantages of financial modernisation paled next to the risks of financial hubris.”

Mr Volcker was right. But Mr Greenspan survived so long because he knew which battles he could not win. Without this flexibility, he would not have kept his position. The independence of central bankers is always qualified. Nevertheless, Mr Greenspan had the intellectual and moral authority to do more. He admitted to Congress in 2008 that: “I made a mistake in presuming that the self-interests of organisations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms.” This “flaw” in his reasoning had long been evident. He knew the government and the Fed had put a safety net under the financial system. He could not assume financiers would be prudent.

Yet Mr Greenspan also held a fear and a hope. His fear was that participants in the financial game would always be too far ahead of the government’s referees and that the regulators would always fail. His hope was that “when risk management did fail, the Fed would clean up afterwards.” Unfortunately, after the big crisis, in 2007-08, this no longer proved true.

If Mr Mallaby faults Mr Greenspan for inertia on regulation, he is no less critical of the inflation-targeting that Mr Greenspan ultimately adopted, albeit without proclaiming this objective at all clearly. The advantage of inflation-targeting was that it provided an anchor for monetary policy, which had been lost with the collapse of the dollar’s link to gold in 1971 followed by that of monetary targeting. Yet experience has since shown that monetary policy is as likely to lead to instability with such an anchor as without one. Stable inflation does not guarantee economic stability and, quite possibly, the opposite.

Perhaps the biggest lesson of Mr Greenspan’s slide from being the “maestro” of the 1990s to the scapegoat of today is that the forces generating monetary and financial instability are immensely powerful. That is partly because we do not really know how to control them. It is also because we do not really want to control them. Readers of this book will surely conclude that it is only a matter of time before similar mistakes occur.

The root problem of 2008 was not that inflation targeting generates instability (even though a higher inflation target then and now would have been very helpful). The root problem of 2008 was not that the Federal Reserve was unwilling to vaporize asset values–the Federal Reserve vaporized asset values in 1982, and stood willing to do so again *if it were to seem appropriate*. The root problem of 2008 was a failure to recognize that the highly leveraged money center banks had used derivatives not to distribute subprime mortgage risk to the broad risk bearing capacity of the market as a whole but, rather, to concentrate it in themselves.

At least as I read Mallaby, he does not criticize Greenspan for “inertia on regulation” nearly as much as he does for Greenspan’s failure to “vaporise citizens’ savings by forcing down asset prices…” even when there is no evidence of rising inflation expectations or excess demand in the goods and labor markets as a whole.

Axel Weber’s full comment:

I think one of the things that really struck me was that, in Davos, I was invited to a group of banks–now Deutsche Bundesbank is frequently mixed up in invitations with Deutsche Bank.

I was the only central banker sitting on the panel. It was all banks. It was about securitizations. I asked my people to prepare. I asked the typical macro question: who are the twenty biggest suppliers of securitization products, and who are the twenty biggest buyers. I got a paper, and they were both the same set of institutions.

When I was at this meeting–and I really should have been at these meetings earlier–I was talking to the banks, and I said: “It looks to me that since the buyers and the sellers are the same institutions, as a system they have not diversified”. That was one of the things that struck me: that the industry was not aware at the time that while its treasury department was reporting that it bought all these products its credit department was reporting that it had sold off all the risk because they had securitized them.

What was missing–and I think that is important for the view of what could be learned in economics–is that finance and banking was too-much viewed as a microeconomic issue that could be analyzed by writing a lot of books about the details of microeconomic banking. And there was too little systemic views of banking and what the system as a whole would develop like.

The whole view of a systemic crisis was just basically locked out of the discussions and textbooks. I think that that is the one big lesson we have learned: that I now when I am on the board of a bank, I bring to that bank a view, don’t let us try to optimize the quarterly results and talk too much about our own idiosyncratic risk, let’s look at the system and try to get a better understanding of where the system is going, where the macroeconomy is going. In a way I take a central banker’s more systemic view to the institution-specific deliberations. I try to bring back the systemic view. And by and large I think that helps me understand where we should go in terms of how we manage risks and how we look at risks of the bank compared to risks of the system.

Must-Read: Nick Rowe: Adding More Periods to Diamond-Dybvig: Fear of Illiquidity, Not Insolvency

Must-Read: Nick Rowe: Adding More Periods to Diamond-Dybvig: Fear of Illiquidity, Not Insolvency: “We simply add an extra time period…. It’s a friendly amendment…

…Agents are ex ante identical. Each agent has an endowment of apples. There is a costless storage technology for apples. There is also an investment technology (planting apples in the ground) which gives a strictly positive rate of return at maturity, but a negative rate of return if you cancel the investment before maturity. Each agent has a 10% probability of becoming impatient (getting the munchies) and wanting to eat all his apples this period. Those probabilities are independent across agents, and there is a large number of agents, so exactly 10% of agents will become impatient each period. Getting the munchies is private information….

Standard Diamond-Dybvig… has… an initial period where agents lend their apples to the bank; a second period where 10% of agents get the munchies and ask for their apples back; and a third period when the investment matures. Banks exist to provide insurance against risk of munchies by pooling assets; normal insurance won’t work because the information is private…. Make it a 4 period model:

  1. An initial period where agents lend their apples to the bank;
  2. A second period where 10% of agents get the munchies and ask for their apples back;
  3. A third period where another 10% of agents get the munchies and ask for their apples back; and
  4. A fourth period when the investment matures….

The bank credibly commits that it will never cancel an investment before maturity, and stores 20% of apples in reserve. In the good equilibrium… only agents who get the munchies ask for their apples back. Now suppose there is a… run on the bank in the second period…. An agent who does not have the munchies in the second period will rationally join that run on the bank, falsely claiming that he does have the munchies… [because] he might get the munchies in the third period, and if the bank suspends redemptions he will be unable to satisfy his future cravings, so he wants to join the line before the bank runs out of stored apples, so he can store apples at home…. Even if people are 100% confident that the bank is solvent, there can still be bank runs if people cannot predict their own future needs for liquidity, and fear that the bank might become illiquid…. Having a deposit in an illiquid bank is functionally not the same as having a deposit in a liquid bank, even if both are solvent…

What I Saw and Did Not See About the Macroeconomic Situation Eight Years Ago: Hoisted from the Archives

Hoisted from the Archives from June 2008J. Bradford DeLong (June 2008): The Macroeconomic Situation, with added commentary:

Looking back, what did I get right or wrong back eight years ago when I was talking about the economy? I said:

  • That the best way to think about things was that we were in a 19th-century financial crisis, and so we should look way back to understand things (RIGHT)
  • That a recession had started (RIGHT), which would probably be only a short and shallow recession (WRONG!!!!)
  • That the Federal Reserve understood (MAYBE) that it has screwed the pooch by failing to prudentially regulate shadow banks, especially in the housing sector (RIGHT), but that it would shortly fix things (MAYBE).
  • That the Federal Reserve was still trying to raise interest rates (RIGHT).
  • That the Federal Reserve should not be trying to raise interest rates (RIGHT), because the tight coupling between headline inflation today and core inflation tomorrow that it feared and expected had not been seen for 25 years (RIGHT).
  • That central bank charters are always drawn up to make financial markets confident that they are tightly bound not to give in to pressure and validate inflation (RIGHT).
  • That, nevertheless, when the rubber hit the road and financial crisis came there was ample historical precedent that central banks were not strictly bound by the terms of their charters–that they were guidelines and not rules (RIGHT).
  • That the Federal Reserve understood these historical precedents (WRONG) and would, with little hesitation, take actions ultra vires to avoid a major financial and economic collapse (WRONG).
  • That there was a long-standing tradition opposed to central banks’ taking action to stem financial crisis and depression–a Marx-Hayek-Mellon-Hoover axis, if yo will (RIGHT).
  • That this axis thought that business cycle downturns were always generated by real-side imbalances that had to be faced via pain and liquidation–could not be papered over by financial prestidigitation (RIGHT).
  • But that this axis was wrong: business cycle downturns, even those to a large degree generated by real-side imbalances, could be papered over by financial prestidigitation (RIGHT).
  • That even though the Fed and the Treasury believed that interest rates should still go up a little bit, they were also engaged in unleashing a huge tsunami of financial liquidity upon the economy (RIGHT).
  • That this liquidity tsunami was appropriate as an attempt to maintain full employment response to the collapse in construction and to the great increase in financial risk (RIGHT).
  • That this liquidity tsunami would do the job, and the recession would be short and shallow (WRONG!!!!!!!!)
  • That the runup in oil prices was not a speculative bubble that would be rapidly unwound (RIGHT).
  • That the runup in oil prices was a headwind for real growth (RIGHT).
  • That the dollar was headed for substantial depreciation (WRONG).
  • That the housing price and housing construction shocks to the economy were still ongoing (RIGHT).
  • That for those with a long time horizon equities were fairly valued, offering higher returns than other asset classes, if risky returns (RIGHT).
  • That asset prices would fluctuate (RIGHT).

But I did not, even in June 2008, understand (a) how bad the derivatives books of the major money-center banks were, and (b) how weak the commitment of central banks to doing whatever was necessary to stabilize the growth path of nominal GDP was.

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Must-Read: Barry Ritholtz: Lending to Poor People Didn’t Cause the Financial Crisis

Must-Read: One of the forms racism takes in America today is the belief that whenever anything goes wrong it must have given money away to poor, shiftless Black people. Today this song is being reprised by–who else?–Larry Kudlow and Steven Moore.

The very sharp Barry Ritholtz does the intellectual garbage cleanup:

Barry Ritholtz: Lending to Poor People Didn’t Cause the Financial Crisis: “Lawrence Kudlow and Stephen Moore have revived an idea… that really should have been put to rest long ago…

…They lay the blame for the credit crisis and Great Recession on the Community Reinvestment Act, a 1977 law designed in part to prevent banks from engaging in a racially discriminatory lending practice known as redlining. The reality is, of course, that the CRA wasn’t a factor…. Here’s the heart of the Kudlow and Moore case:

The seeds of the mortgage meltdown were planted during Bill Clinton’s presidency. Under Clinton’s Housing and Urban Development (HUD) secretary, Andrew Cuomo, Community Reinvestment Act regulators gave banks higher ratings for home loans made in ‘credit-deprived’ areas. Banks were effectively rewarded for throwing out sound underwriting standards and writing loans to those who were at high risk of defaulting. If banks didn’t comply with these rules, regulators reined in their ability to expand lending and deposits.

They then argue that this was part of a broader campaign to make loans to unqualified low-income folk, which in turn caused the crisis…. The CRA… simply says that if you open a branch office in a low income neighborhood and collect deposits there, you are obligated to do a certain amount of lending in that neighborhood. In other words, you can’t open a branch office in Harlem and use deposits from there to only fund loans in high-end Tribeca. A bank must make credit available on the same terms in both neighborhoods. In other words, a ‘red line’ can’t be drawn around Harlem….

Showing that the CRA wasn’t the cause of the financial crisis is rather easy. As Warren Buffett pal Charlie Munger says, ‘Invert, always invert.’ In this case, let’s assume Moore and Kudlow are correct…. What would that world have looked like?…. (a) Home sales and prices in urban, minority communities would have led the national home market higher, with gains in percentage terms surpassing national figures. (b) CRA mandated loans would have defaulted at higher rates. (c) Foreclosures in these distressed urban CRA neighborhoods should have far outpaced those in the suburbs. (d) Local lenders making these mortgages should have failed at much higher rates. (e) Portfolios of banks participating in the Troubled Asset Relief Program should have been filled with securities made up of toxic CRA loans. (f) Investors looking to profit should have been buying up properties financed with defaulted CRA loans. (g) And Congressional testimony of financial industry executives after the crisis should have spelled out how the CRA was a direct cause, with compelling evidence backing their claims.

Yet none of these things happened. And they should have, if the CRA was at fault…. If that isn’t enough to dismiss the claim, consider this: Where did mortgages, especially subprime mortgages, default in large numbers? It wasn’t Harlem, Philadelphia, Baltimore, Chicago, Detroit or any other poor, largely minority urban area covered by the CRA. No, the crisis was worst in Florida, Arizona, Nevada and California. Indeed, the vast majority of the housing collapse took place in the suburbs and exurbs…. What’s more, many of the lenders that made the subprime loans that contributed so much to the collapse were private non-bank lenders that weren’t covered by the CRA. Almost 400 of these went bankrupt soon after housing began to wobble. I have called the CRA blame meme ‘the big lie’–and with good reason. It’s an old trope, tinged with elements of dog-whistle politics, blaming low-income residents in the inner cities regardless of what the data show…

Let’s see how much of the media picks up on this dog megaphone, and presents it to the public as trustworthy information intermediaries should…

Lack of Demand Creates Lack of Supply; Lack of Proper Knowledge of Past Disasters Creates Present and Future Ones

FRED Graph FRED St Louis Fed

“We have lost 5 percent of capacity… $800 billion[/year]…. A soft economy casts a substantial shadow forward onto the economy’s future output and potential.” It is now three years later than when Summers and the rest of us did these calculations. If you believe Janet Yellen and Stan Fischer’s claims that we are now effectively at full employment, the permanent loss of productive capacity as a result of the 2007-9 financial crisis, the resulting Lesser Depression, and the subsequent bobbling of the recovery is not 5% now. It is much closer to 10%. And it is quite possibly aiming for 15% before it is over:

Lawrence Summers et al. (2014): Lack of Demand Creates Lack of Supply: “Jean-Baptiste Say, the patron saint of Chicago economists…

…enunciated the doctrine in the 19th century that supply creates its own demand…. If you produce things… you would have to create income… and then the people who got the income would spend the income and so how could you really have a problem[?]… Keynes… explain[ed] that [Say’s Law] was wrong, that in a world where the demand could be for money and for financial assets, there could be a systematic shortfall in demand.

Here’s Inverse Say’s Law: Lack of demand creates, over time, lack of supply…. We are now in the United States in round numbers 10 percent below what we thought the economy’s capacity would be today in 2007. Of that 10 percent, we regard approximately half as being a continuing shortfall relative to the economy’s potential and we regard half as being lost potential…. We have lost 5 percent of capacity… we otherwise would have had…. $800 billion[/year]. It is more than $2,500[/year] for every American…. A soft economy casts a substantial shadow forward onto the economy’s future output and potential. This might have been a theoretical notion some years ago, it is an empirical fact today…

What are we going to do?

Well, we are going to do nothing–or, rather, next to nothing. Life would be convenient for the Federal Reserve if right now (a) the U.S. economy were at full employment, (b) a rapid normalization of interest rates were necessary to avoid inflation rising significantly above the Federal Reserve’s 2%/year PCE chain index inflation target, and (c) U.S. tightening were more likely to stimulate economies abroad via greater opportunities to sell to the U.S. than contract economies abroad by withdrawing risk-bearing capacity. And the Federal Reserve appears to have decided to believe what makes life convenient. Thus nothing additional in the way of action to boost the economy can be expected from monetary policy. And on fiscal policy a dominant or at least a blocking position is held by those who, as the very sharp Olivier Blanchard put it recently, even though:

[1] In the short run, the demand for goods determines the level of output. A desire by people to save more leads to a decrease in demand and, in turn, a decrease in output. Except in exceptional circumstances, the same is true of fiscal consolidation [by governments]…

nevertheless Olivier Blanchard:

was struck by how many times… [he] had to explain the “paradox of saving” and fight the Hoover-German line, [2] “Reduce your budget deficit, keep your house in order, and don’t worry, the economy will be in good shape”…

Apparently he was flabbergasted by the number of people who would agree with [1] in theory and yet also demand that policies be made according to [2], and he plaintively asks for:

anybody who argues along these lines must explain how it is consistent with the IS relation…

Remember: the United States is not that different. As Barry Eichengreen wrote:

It is disturbing to see the refusal of [fiscal] policymakers, particularly in the US and Germany, to even contemplate… action, despite available fiscal space (as record-low treasury-bond yields and virtually every other economic indicator show). In Germany, ideological aversion to budget deficits runs deep… rooted in the post-World War II doctrine of “ordoliberalism”…. Ultimately, hostility to the use of fiscal policy, as with many things German, can be traced to the 1920s, when budget deficits led to hyperinflation. The circumstances today may be entirely different from those in the 1920s, but there is still guilt by association, as every German schoolboy and girl learns at an early age.

The US[‘s]… citizens have been suspicious of federal government power, including the power to run deficits…. From independence through the Civil War, that suspicion was strongest in the American South, where it was rooted in the fear that the federal government might abolish slavery. In the mid-twentieth century… Democratic President Lyndon Baines Johnson’s “Great Society”… threatened to withhold federal funding for health, education, and other state and local programs from jurisdictions that resisted legislative and judicial desegregation orders. The result was to render the South a solid Republican bloc and leave its leaders antagonistic to all exercise of federal power… a hostility that notably included countercyclical macroeconomic policy. Welcome to ordoliberalism, Dixie-style. Wolfgang Schäuble, meet Ted Cruz…

The world very badly needs an article–a long article, 20,000 words or so. It would teach us how we got into this mess, why we failed to get out, and how the situation might still be rectified–so that the Longer Depression of the early 21st century does not dwarf the Great Depression of the 20th century in future historians’ annals of macroeconomic disasters. Such a book would have to assimilate and transmit the lessons of what I think of as the six greatest books on our current ongoing disaster:

Plus it would have to summarize and evaluate Larry Summers’s musings on secular stagnation.

We were lucky that John Maynard Keynes started writing his General Theory summarizing the lessons we needed to learn from the Great Depression even before that depression reached its nadir. But we were not lucky enough. As Eichengreen stresses, only half the lessons of Keynes were assimilated–enough to keep us from repeating the disaster, but not enough to enable us to get out of it. (Although, to be fair, the world of the 1940s emerged from it only at the cost of imbibing the even more poisonous and deadly elixir called World War II.)

Paul? (Krugman, that is.) Are you up to the task?

Must-read: Anat Admati: “The Missed Opportunity and Challenge of Capital Regulation”

Must-Read: Anat Admati: The Missed Opportunity and Challenge of Capital Regulation: “Capital regulation is critical to address distortions and externalities…

…from intense conflicts of interest in banking and from the failure of markets to counter incentives for recklessness. The approaches to capital regulation in Basel III and related proposals are based on flawed analyses of the relevant tradeoffs. The flaws in the regulations include dangerously low equity levels, complex and problematic system of risk weights that exacerbates systemic risk and adds distortions, and unnecessary reliance on poor equity substitutes. The underlying problem is a breakdown of governance and lack of accountability to the public throughout the system, including policymakers and economists.

Must-read: Simon Wren-Lewis: “Can Central Banks Make Three Major Mistakes in a Row and Stay Independent?”

Must-Read: Simon Wren-Lewis: Can Central Banks Make Three Major Mistakes in a Row and Stay Independent?: “Mistake 1: If you are going to blame anyone for not seeing the financial crisis coming…

…it would have to be central banks. They had the data that showed a massive increase in financial sector leverage. That should have rung alarm bells, but instead it produced at most muted notes of concern about attitudes to risk. It may have been an honest mistake, but a mistake it clearly was.

Mistake 2: Of course the main culprit for the slow recovery from the Great Recession was austerity, by which I mean premature fiscal consolidation. But the slow recovery also reflects a failure of monetary policy…. Monetary policy makers should have said very clearly… that fiscal stimulus would have helped them do that job….

What could be mistake 3: The third big mistake may be being made right now in the UK and US… supply side pessimism. Central bankers want to ‘normalise’ their situation… writing off the capacity that appears to have been lost as a result of the Great Recession…. In both cases the central bank is treating potential output as something that is independent of its own decisions and the level of actual output. In other words it is simply a coincidence that productivity growth slowed down significantly around the same time as the Great Recession. Or if it is not a coincidence, it represents an inevitable and permanent cost of a financial crisis. Perhaps that is correct, but there has to be a fair chance that it is not…. What central banks should be doing in these circumstances is allowing their economies to run hot for a time….

If we subsequently find out that their supply side pessimism was incorrect (perhaps because inflation continues to spend more time below than above target, or more optimistically growth in some countries exceed current estimates of supply without generating ever rising inflation), this could spell the end of central bank independence. Three counts and you are definitely out?

Must-read: Simon Wren-Lewis: “The Financial Crisis, Austerity and the Shift from the Centre”

Must-Read: Simon Wren-Lewis: The Financial Crisis, Austerity and the Shift from the Centre: “Think of two separate one dimensional continuums…

…one economic, with neoliberal at one end and statist at the other, and the other something like identity. Identity can take many forms. It can be national identity (nationalism at one end and internationalism at the other), or race, or religion, or culture, or class. Identity politics is stronger on the right…. For the political right identity in terms of class can work happily with neoliberalism, but identity in terms of the nation state, culture and perhaps race less so…. When neoliberalism is discredited, this potential contradiction on the right becomes more evident… [as] politicians on the right use identity politics to deflect attention from the consequences of neoliberalism…. Identity has always been strong on the right, so it is a little misleading to see it as only something that the right uses in an instrumental way….

None of this detracts from the basic point that Quiggin makes: the apparent drift from the political centre ground is a consequence, for both left and right, of the financial crisis…. One interesting question for me is how much the current situation has been magnified by austerity. If a larger fiscal stimulus had been put in place in 2009, and we had not shifted to austerity in 2010, would the political fragmentation we are now seeing have still occurred? If the answer is no, to what extent was austerity an inevitable political consequence of the financial crisis, or did it owe much more to opportunism by neoliberals on the right, using popular concern about the deficit as a means by which to achieve a smaller state? Why did we have austerity in this recession and not in earlier recessions? I think these are questions a lot more people on the right as well as the left should be asking.