Some broad lessons from the GFC

I had to do a brief chat about the Global Financial Crisis, “mistakes” that were made, and the role of the international financial architecture, for a organisation I’m not naming with people I’m not naming.  It was Chatham House rules, but nothing particularly rough was said – so I’m more not naming anything as I like to let people’s minds run wild!  Anyway, here are the notes I wrote for myself in preparation – make of them what you will.

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Comparing recessions: Unemployment in New Zealand

Keeping in mind Shamubeel’s point that we need to be careful looking at aggregates, I thought it would be nice to update the graph from this post back in early-2009 – when people were talking about 11% unemployment (Note:  I have moved both series across a year).

 

Cheers Statistics NZ.

This supports the type of story we have seen from the employment rate data, and our suggestion here that the 87-92 period was incredibly ugly for NZ.  As a result, even though in GDP terms the current slowdown looks like one of the worst NZ has experienced (though not so much in RGNDI terms – given the lift in NZ’s terms of trade) overall employment and unemployment outcomes have thankfully been nowhere near as bad as in the early 1990s.  I’m looking forward to all the analysis that will appear sifting through the data and working out why this is the case ;)

 

Five year anniversary of Lehman Brothers

Sunday was the 5-year anniversary of the failure of Lehman Brothers – there was a live-streaming Twitter account, an good article by Liam Dann reminiscing, and a pointer to what he wrote about the crisis at the time.

Given how well his article held up, I was tempted to see what embarrassing things I said at the time – given that the magnitude of the deterioration was definitely worse than I could tell in real time.  Luckily, my posts are simply descriptive things pointing out some of the factors we need to keep an eye on (here on the day, here a few days later) – my view of the situation had shifted significantly since the failure of Bear Sterns in March (where I comment about moral hazard in comments).

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The Economist on the GFC

The Economist magazine has started a five part series on the Global Financial Crisis, and the lessons from it.  Should be a lot of fun.  Part one is here.  They conclude:

The regulatory reforms that have since been pushed through at Basel read as an extended mea culpa by central bankers for getting things so grievously wrong before the financial crisis. But regulators and bankers were not alone in making misjudgments. When economies are doing well there are powerful political pressures not to rock the boat. With inflation at bay central bankers could not appeal to their usual rationale for spoiling the party. The long period of economic and price stability over which they presided encouraged risk-taking. And as so often in the history of financial crashes, humble consumers also joined in the collective delusion that lasting prosperity could be built on ever-bigger piles of debt.

A lot of what they say in the article is true, although I will be honest that I don’t fully agree with their description of the lead up to the crisis … and as a result, will probably have some differences of opinion in terms of what I view as appropriate lessons.  However, I will leave all this for another time ;) [Note:  Many of these things involve markets - but then many of the explanations involve only looking at "one side".  This is common, but always a touch disingenuous IMO]

Feel free to discuss the GFC, and the description of the causes by the Economist, in comments below!

Sumner on Borio

A quote via Scott Sumner:

But debt doesn’t make workers want to work less, it makes them want to consume less.  There is a difference.  We need economists to look through these framing effects, and see that the standard model that demand shocks cause high unemployment worked fine; it’s our policymakers who failed us.

There is a huge difference.  Economists say GDP = C + I + G + X – M – but in macro you can’t just take these individual factors and talk about their impact on GDP, they are all massively endogenous.  In other words, this decomposition can be misleading – and gets filled with “fallacy of composition” issues when people try to use it for policy!

“GDP” is produced by factors of production, it is output using labour and other factors.  People are worried about high unemployment, and underutilised resources, this is exactly what Sumner is talking about when discussing active monetary policy of “demand management”.

The obsession with including “finance” into the cycle has to be viewed carefully.  In so far as it improves forecasts, and thereby improves the ability to “target a path” for demand, and improves our understanding of “what could or will happen” it is very very useful.  But it doesn’t actually change the fundamental relationship that monetary authorities should be focused on when setting monetary conditions!

Now this is where I get concerned with Borio’s stuff.  There is a lot of very good work in there (I agree with a lot of the discussion of the financial industry – and using financial indicators to “add information” about the output gap), but he is obsessed with selling his work “output gap that is adjusted for finance” or a “finance neutral output gap”.  This framing doesn’t make any sense to me – and in my reading of his papers he has never provided a full methodological reason why the output gap measure should be sold in this way.  He attempts it post-hoc justifications of why finance impacts on deviations from potential bullet two of this Vox Eu article – but this is still an uncompelling base.  When it comes to monetary policy the actual counterfactual we are interested in is in terms of unemployment and inflation – other factors matter (in terms of monetary policy) only INSOFAR as they influence these!

Macroprudential policy yadda yadda yadda are structural policies about “real economy” issues – monetary policy is set GIVEN these.  But having monetary authorities focus on this instead of actual monetary conditions is missing the wood for the trees.  Financial market information is useful to help inform us of where we are, and where we are going, BUT can we actually focus on the first order issue of the purpose of “active monetary policy” which are medium-long term inflation outcomes and short term unemployment variation (read the short-term as the outlook for 18-24 months out, I realise this term can be vague otherwise!).  If the financial market information helps the central bank set policy to deliver this (which it will) use the hell out of it – but don’t then lose sight of your actual purpose and start trying to value companies and assets for the market at large.  If you want to do that monetary institutions, give up your contract with government and get a job as a financial adviser ;)

When I read this sort of stuff all I see is monetary theorists saying “ahhh, NGDP growth was weaker than authorities were committed to delivering, here are some excuses”.  But as soon as they give up the role they were given by government (deal with inflation and short term fluctuations in the UR) they leave themselves increasingly open to arbitrary demands and politicisation.

After ignoring prudential standards and arbitrarily trying to deal with it with monetary policy, we stumbled into the Great Depression.  Pressure post Great Depression and war, in time led to the hyperinflation and stagflation through the 1970/80s, which led to a recognition that policy needed to narrow.  Which led to completely ignoring macroprudential rules (which is not good either) which then led to the 2008/09 crisis. Which led to …

Fair point

From this entertaining discussion of the Rethinking Macroeconomics II conference comes this gem (ht Economist’s View)

8) Can we realistically solve the “too big to fail” problem?

We have to solve it. If we can’t, then nationalize these behemoths and pay the people who run them the same wages as everyone else who work for the government.

Fair call, economists, like most people, despise “socialism for the rich”.  And honestly, if public institutions are always going to backstop them then nationalisation makes a lot of sense – and is how we felt here during some of the financial firm bailouts.

I can’t see the government letting banks fail, which is why I’ve been pro-deposit insurance recently (here, here).  But even down that road, have a deposit levy.  Also ask why we are going down that road, is it because we want a “risk free” rate of return for mum and dad investors no matter the cost … if that is the social preference Bair’s suggestion of nationalisation starts to make a lot more sense right ;)