Times are bad and getting badder?

The crash of 1921. I certainly didn’t know about it before reading James Grant’s most enjoyable new book, The Forgotten Depression: The Crash That Cured Itself. It sent Harry Truman’s haberdashery store in Kansas City into bankruptcy, among many other businesses. It was bad enough that there was even a song about it, Ain’t We Got Fun?: “Times are bad and getting badder/ Still we have fun.”

It is certainly not received wisdom that the downturn of 1921 classes as a depression – and, as the book notes, people were not yet speaking about ‘the economy’, although the terms inflation and deflation were in use. Yet GNP fell 24% in nominal terms in 1921, 9% in real terms. Industrial production fell twice as much in 1920-21 as it did in 2007-9. As an aside, I love the Oskar Morgenstern description here of the aggregate economic statistics as “an opinion in quantitative form.” (I’ve made a note to read Morgenstern’s On The Accuracy of Economic Observations, which sounds a corker just from the title.)

I learned a lot from The Forgotten Depression. The early 1920s are a lacuna, in my knowledge and I think generally in historical overviews, as the period is understandably overshadowed by the Great War and its immediate aftermath beforehand, and the crash of 1929 and the Great Depression afterwards. This book is an excellent supplement from the US perspective of the monetary and central banking pre-history to the period covered in Liaquat Ahamed’s Lords of Finance about the 1930s. The early history of the Federal Reserve system, the move away from a strict gold standard, and the development of monetary policy – intensely debated – are described here in just the right amount of detail.

As the subtitle makes plain, James Grant (famous of course for his Interest Rate Observer) argues that the absence of any economic stimulus policy in 1921 meant the forgotten depression was acute but brief. It corrected itself in about a year, through the price mechanism – lower prices for goods and labour moved output and employment back up within a relatively short time. The federal budget was balanced. The Federal Reserve raised interest rates rather than lowering them. By contrast in 1929 the government piled in with policies to prevent wages falling and introduced deficit spending – and, as we know, that was anything but a shortlived depression. The reader is clearly meant to carry over the lesson to our own context.

I doubt the argument will change minds, given the entrenched positions people have at present over the contribution of stimulus versus austerity in explaining the paths different economies have taken since 2008. Reading The Forgotten Depression made me reflect on the impossibility of identifying empirically cause and effect at the macro level: it is simply impossible to isolate the contributions of specific policies and timings, given not only Milton Friedman’s “long and variable” lags in the effect of monetary (and fiscal) policy but also the importance of initial conditions, specific contextual events, different economic structures, and the sheer complexity of a modern economy (especially compared to that of the 1920s). For example, I’m sure a macroeconomist of a different disposition could make the opposite case to Mr Grant’s, and argue that the hike in interest rates in January 1920 (a 1.25% point rise in one go, to counter the post-war inflationary surge) turned a mild slowdown into a serious downturn.

There is an awful lot to be said for governments not trying to fine tune (or even approximately tune) the economy, given the general sea of uncertainty; equally the possibility of low-activity traps is evidently non-trivial, and it takes co-ordinated action to get out of them. The debt and financial market context in 2008 was so very different from that of 1920-21 that I’m not persuaded there are clear lessons for today from the forgotten depression. As the book concludes: “There are no controlled experiments in economics.”

But that does not mean we have nothing to learn from history – on the contrary, it is only history that teaches proper humility about the limits of economic knowledge and tools. I strongly recommend reading The Forgotten Depression - with an open mind – and thinking about its central point about that markets are (sometimes) a highly effective self-correcting process.


Unknown knowns about financial markets

Robert Shiller’s point, in the new edition of Irrational Exuberance, about the lack of attention paid to the warning signals of bubbles, has been preoccupying me. The attention problem was the theme of a conference at the Toulouse School of Economics a couple of years ago, as well as books like The Invisible Gorilla by Chris Chabris and Dan Simons.


Of course, this isn’t just an issue in financial markets. One of the interesting essays in Rebecca Solnit’s Encyclopedia of Trouble and Spaciousness, which I read recently, riffs on Donald Rumsfeld’s famous known knowns, known unknowns, and unknown unknowns, adding a fourth category (which she attributes to Slavoj Zizek) of unknown knowns. In her essay, the context is the scale of the US economy and policy devoted to military resources. In the financial markets, it is the existence of bubbles or stresses that exist in the data – in the world – but are not seen.

Or seen, but not allowed to rise to conscious thought and action. In the year or two before the 2008 crisis, the signals were (with hindsight) very clear – an inverted yield curve, and super-high PE ratios and house price-earnings ratios. Few people paid attention, however. But it’s extraordinarily hard to be just about the only person paying attention to unknown knowns. The Office of Financial Research was intended to be a post-crisis solution to this problem, gathering data and developing visualisations or effective methods of monitoring the markets. I don’t think it has the hoped-for impact.

Next year’s reading

At the end of the year I’ll do my usual round-up of forthcoming economics and business books, but I can’t resist mentioning a few tantalising titles my own publisher, Princeton University Press, is bringing out next spring. As the author of GDP: A Brief But Affectionate History, I will have to read Dirk Philipsen’s The Little Big Number: How GDP Came to Rule the World and What to Do About It. Francois Bourguignon has The Globalization of Inequality out in June. Ian Morris – author of the fabulous Why the West Rules – For Now – has a new book, Foragers, Farmers and Fossil Fuels: How human values evolve.


There are many more, in a terrific list, but I also can’t resist mentioning two new books on Benford’s Law, An Introduction to Benford’s Law by Arno Berger and Theodore Hill, and Benford’s Law: Theory and Applications edited by Steven Miller. Benford’s Law says the first digits of data sets (such as economic statistics) are not uniformly distributed from one to nine – it helped reveal the fact that Greek economic statistics prior to the crisis were not accurate.

Exuberance, animal spirits and identity

The arrival this week of Robert Shiller’s revised edition of his wonderful book Irrational Exuberance was timely, because it came in the wake of Aditya Chakrabortty’s radio programme about the teaching of economics. One of the the bizarre claims made in the programme is that mainstream economics is fixated on rational choice models. Shiller’s work on finance, for which he received the Nobel Prize of course, serves as Exhibit One in showing this claim to be incorrect. (Tony Yates blogged about this and other issues with the programme.)

The new preface to Irrational Exuberance begins: “One might think that years after the bursting of the speculative bubbles that led to the 2007-9 world financial crisis, we should be living in a distinctly different post-bubble world. One might think that people had learned their lesson, and would not again pile into expanding markets.” But no. Although the situation isn’t as fragile now as in 2000 (ahead of the 1st edition) or 2005 (2nd edition), Prof Shiller clearly thinks there is renewed potential for a crash somewhere. The bond market is clearly a leading candidate. One substantial addition to the book is a chapter on the bond market, which he believes has a high probability of currently being in a bubble, vulnerable to bursting. But it isn’t just bond markets that could be bubbly, but also equities: the ratio of real share prices divided by the ten-year average of real earnings in the US is higher than it has been at any time except 1929, 2000 and 2007.

Interestingly, the book suggests that the psychology of bubbles is not one of firm belief that a crash cannot happen, but rather one of inattention to evidence that it might or will do. This is in line with work Paul Seabright at the Toulouse School of Economics has beein doing on attention – or its lack. A second kind of addition to this 3rd edition is the integration of Shiller’s thinking on psychology since his book Animal Spirits co-authored with George Akerlof. Akerlof has continued to work on this too, including his very interesting work with Rachel Kranton on the role of identity in economic choices, in Identity Economics.


Irrational Exuberance is a classic and it is essential reading on economics and financial markets; for anyone who hasn’t yet read it, this 3rd edition brings the contextual information up to date and expands on the psychological insight of the original. I should add, Robert Shiller is the most prominent exemplar of economists using decision assumptions and frameworks other than ‘rational choice’ but he has plenty of company in the profession – in fact, it’s pretty mainstream nowadays.

Adam Smith for our times

Adam Smith’s The Theory of Moral Sentiments has had something of a revival in recent times. Emma Rothschild’s Economic Sentiments focused on it, and Nicholas Phillipson’s recent biography of Smith, Adam Smith: An Enlightened Life underlined its importance in Smith’s thinking. My own dear publisher Peter Dougherty also gave it due credit in his Who’s Afraid of Adam Smith: How the Market got its Soul. So, while still far less well-known and less widely read than The Wealth of Nations, Moral Sentiments is creeping onto the intellectual radar of our times – we are rediscovering the Adam Smith we need now.

It gets a deserved boost from Russ Roberts’ new book, How Adam Smith Can Change Your Life (which I read in manuscript and provided a little comment for). This is a delightful book translating Smith’s 18th century prose into a 21st century guide to individual and collective living well. I choose that phrase because it isn’t just a guide to leading the Aristotelian good life, nor a book about how to run the economy better, but combines the two into insights about how wise choices can help the individual and society.

For example, in the chapter ‘How to Make the World a Better Place,’ Roberts says: “In The Theory of Moral Sentiments, Smith describes how individual choices can lead to important social outcomes. He’s talking about something more important than the price of apples. He’s describing the role each of us plays in creating a moral society.” And he goes on to explain how emergent social norms create the standards or proper, moral behaviour. “Smith argues that norms and culture are the result of the tiny and infinitely numerous and subtle ways we interact.” I particularly like this chapter. It combines Hayek and Ostrom in a rather unexpected way.

The chapters have titles such as ‘How to be Happy, ‘How Not to Fool Yourself’, ‘How to be Loved’, ‘How to Live in the Modern World.’ The last of these links The Theory of Moral Sentiments and The Wealth of Nations, explaining that they share the same world view, the same view of human nature, but apply it to different domains, the personal and the commercial.  “A modern person has to inhabit two worlds at the same time, a world that is intimate and a world that is distant, a world that is held together by love, and a world that is held together by prices and monetary incentives.”

Russ Roberts will be known to many readers of this blog for his Econtalk podcasts, a huge public service. He’s an excellent writer – I am a fan of his novels, The Invisible Heart and The Price of Everything.  If you haven’t read A Theory of Moral Sentiments, or if you have and would like an enjoyable reminder, How Adam Smith Can Change Your Life is a pleasure to read.