Financial crises, past, recent and future

Very late in the day, I’ve finally read Barry Eichengreen’s Hall of Mirrors: The Great Depression, The Great Recession and the Uses – and Misuses – of History. The subtitle is a concise capsule summary. The book does a neat job weaving between the 1920s/30s and the 2000s, underlining the similarities and the significant differences. There is some nice storytelling as well, particularly in the Great Depression chapters, using colourful figures and their exploits to draw in the reader, starting with the notorious Charles Ponzi but with many others too. In fact, there’s a 20 page Dramatis Personae, so this is no abstract text but a story of actual people doing actual (bad/stupid/short-sighted) things.

Given the number of books already available about both episodes, the added value of this one needs to be in the compare and contrast, and I think it succeeds in this. The common features (apart from human frailty) lie in the dynamics of bubbles, and their roots in periods of stability and optimism; in the global character of financial market reactions and the way decisions that seem either sensible or politically necessary in one country can have immense negative externalities for others; and in the interplay between politics and economics or between democracy and technocracy. Perhaps the most important difference emphasised here is the greater scale and complexity of financial markets now. Even when people are not trying to hide misdeeds, it is not easy to identify dangerous flows or accumulations of risk.

But the book also points to the difference in policy responses: in the Great Depression the answer was more government. Given the way politics has moved, it was not the answer to the Great Financial Crisis. Eichengreen – relatively gently – points to the under-regulation of big banks and other financial institutions in key dimensions, such as the only modestly higher capital ratios and lower leverage; or the failure to reform credit ratings agencies. This gently touch, he argues, reflects the success of the monetary and fiscal policy action to avert another Great Depression: “Thus the very success with which policy makers limited the damage from the worst financial crisis in eighty years means we are likely to see another such crisis in less than eighty years.

Much less, I’d say, given how little has changed.

Anyway, I enjoyed Hall of Mirrors. I think it helps to have read other books on both episodes, as in effect half a book on each of the Great Depression and the Financial Crisis is pretty compressed. A combination of Liaquat Ahamed’s Lords of Finance and John Lanchester’s Whoops! would be perfect preparation (the latter was IOU in the US).


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, [amazon_link id=”1451686455″ target=”_blank” ]The Forgotten Depression: The Crash That Cured Itself[/amazon_link]. 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.”

[amazon_image id=”1451686455″ link=”true” target=”_blank” size=”medium” ]The Forgotten Depression: 1921: The Crash That Cured Itself[/amazon_image]

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 [amazon_link id=”B00177CAI0″ target=”_blank” ]On The Accuracy of Economic Observations[/amazon_link], which sounds a corker just from the title.)

I learned a lot from [amazon_link id=”1451686455″ target=”_blank” ]The Forgotten Depression[/amazon_link]. 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 [amazon_link id=”009949308X” target=”_blank” ]Lords of Finance[/amazon_link] 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 [amazon_link id=”1451686455″ target=”_blank” ]The Forgotten Depression[/amazon_link] 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 [amazon_link id=”1451686455″ target=”_blank” ]The Forgotten Depression [/amazon_link]- with an open mind – and thinking about its central point about that markets are (sometimes) a highly effective self-correcting process.

Walter Lipmann, public economist

A new biography, [amazon_link id=”0674368134″ target=”_blank” ]Walter Lippmann: Public Economist[/amazon_link] by Craufurd Goodwin, is a very interesting portrait of someone not all that well known now. I ended it appreciating that Lippmann was a more important figure in early 20th century America than I’d realised, perhaps a Martin Wolf of his day. The mixture of intellectual rigour and status with an ability and urge to communicate with the wider public is relatively rare, and important in modern democracies, with all their political and economic complexities. Lippmann was probably the first ‘public economist’.

I was aware of Lippmann only through his 1920 book [amazon_link id=”0691134804″ target=”_blank” ]Liberty and the News[/amazon_link], which for some random reason sits on my shelves, and [amazon_link id=”1484150295″ target=”_blank” ]Public Opinion[/amazon_link], published in 1922. The biography concentrates instead on his books and columns on economics and political economy, tracing the development of his thought as he watched the Depression and war unfold, and engaged with both Keynes’s and Hayek’s work. Throughout the decades, however, in an era when the old order was dying, Lippmann challenged the attractive certainties of the extremes, observing that ‘free’ markets had never existed, and that collectivism relied on censorship, spying and terror. This search for a way to manage the modern economy, and deliver to voters in democracies the economic well-being or assurance they demanded, while safeguarding liberty, remained his theme throughout, above all in [amazon_link id=”1178812782″ target=”_blank” ]The Good Society[/amazon_link].

Lippmann sounded (in [amazon_link id=”1560005599″ target=”_blank” ]The Method of Freedom[/amazon_link]) rather like a modern behavioural economist: “The classical economists over-estimated the enlightenment which is based on self-interest and the fortitude based on self-reliance. … Imitation, the herd instinct, the contagion of numbers, fashions, moods, rather than enlightened self-interest, have tended to govern the economy.” And elsewhere, he emphasised the importance of institutions, regretting the fact that economists had not combined their powerful analysis with a ‘humanly satisfactory’ social philosophy. Economics needed to show concern not only with liberty, but with a ‘concern always for those who could not cope with modernity,’ as Goodwin puts it.

Lippmann, always interested in education and closely involved in the economics department at Harvard, was unable, though, to resist the tide of increasing specialization, to stop the schism between the humanities and social sciences, or the isolation of economics from politics, philosophy, psychology and history. What a shame.

This is a timely biography. Lippmann’s concern to navigate through the real complexities and uncertainties of a transitional, even revolutionary, economic era while avoiding the appealing, easy answers was admirable. So was his determination to explain to fellow citizens the economic debates of the day. Not surprisingly, I find the idea of a public economist very attractive. As a character, Lippmann seems slightly unappealing – brilliantly successful from his undergraduate days on and wholly plugged in to the establishment, he comes across as rather smug, although this is no doubt partly because of my anachronistic reading of his letters as quoted here. There is also perhaps a bit too much detail in the book for the mildly interested reader, although having said that it is well-written and not at all too long. Lippmann is well worth re-discovering as we continue through our own period of economic and political upheaval, and this book sheds light on what made him an important figure who deserves to be better known.

[amazon_image id=”0674368134″ link=”true” target=”_blank” size=”medium” ]Walter Lippmann: Public Economist[/amazon_image]

[amazon_image id=”1178812782″ link=”true” target=”_blank” size=”medium” ]The Good Society[/amazon_image]  [amazon_image id=”1484150295″ link=”true” target=”_blank” size=”medium” ]Public Opinion[/amazon_image]

The debt overhang

Larry Summers today reviews in the FT [amazon_link id=”022608194X” target=”_blank” ]House of Debt [/amazon_link]by Atif Mian and Amir Sufi, praising it highly – except in one respect. Amusingly, he starts out by emphasising that it is the most important economics book of 2014, based on unchallengeable data and clearly written. Still, (not so) subtle side-swipes at [amazon_link id=”067443000X” target=”_blank” ]Capital in the 21st Century [/amazon_link]aside, Summers’ acceptance of the argument in [amazon_link id=”022608194X” target=”_blank” ]House of Debt[/amazon_link] is significant, given his key role in responding to the financial crisis. The book argues that the roots of the crisis lie not in the banking or shadow banking system but in household over-leverage, drawing on a line of argument dating back to [amazon_link id=”1469947080″ target=”_blank” ]Irving Fisher[/amazon_link] and running more recently through [amazon_link id=”0470824948″ target=”_blank” ]Richard Koo’s work on Japan[/amazon_link].

[amazon_image id=”022608194X” link=”true” target=”_blank” size=”medium” ]House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent it from Happening Again[/amazon_image]

Where Summers disagrees with the book concerns the authors’ interpretation of the policy response, criticising the authorities’ failure to tackle the mortgage overhang more directly with sweeping relief for over-indebted households. Summers writes: “Obviously, as the director of President Barack Obama’s National Economic Council in 2009 and 2010, I am an interested party here. It seems to me that Mian and Sufi are naive on policy.”

There is support for Summers’ point that implementation of more extensive mortgage debt relief simply could not get through Congress in one of the essays I’ve just read in [amazon_link id=”0231160755″ target=”_blank” ]The Best Business Writing 2013[/amazon_link], The Great American Foreclosure Story by ProPublica’s Paul Kiel. In general, I think economists – even those with a tremendous interest in policy issues – fail to take into account the sheer difficulty of implementing anything in a modern democratic polity, where politics meets complexity. Just glance at [amazon_link id=”1780742665″ target=”_blank” ]The Blunders of Our Governments[/amazon_link] by Anthony King and Ivor Crewe….

[amazon_image id=”1780742665″ link=”true” target=”_blank” size=”medium” ]The Blunders of Our Governments[/amazon_image]

[amazon_link id=”022608194X” target=”_blank” ]House of Debt[/amazon_link] sounds like an essential read on the crisis. I wonder if any economists are doing similar empirical work on household indebtedness in the European economies?

Lessons from the past

My Tube reading lately has been chapters from an excellent new book edited by Nick Crafts and Peter Fearon, [amazon_link id=”0199663181″ target=”_blank” ]The Great Depression of the 1930s: Lessons for Today[/amazon_link]. The comparison between the present day and the 30s has made frequent appearances in post-crisis commentary, so work by economic historians investigating the similarities and differences in forensic empirical detail is most welcome. The cast list of contributors for this book is impressive too, including Charles Calomiris, Timothy Hatton, Barry Eichengreen and other econ history stars.

[amazon_image id=”0199663181″ link=”true” target=”_blank” size=”medium” ]The Great Depression of the 1930s: Lessons for Today[/amazon_image]

In the first two chapters, the editors first give an overview of international experience in the 1930s, and then what lessons that might hold for the present day. They would serve as a stand-alone overview of the issues. The big headline is that among all the causes of the Depression in the 30s, the constraint imposed by the gold standard combined with US and French accumulation of gold stands out for its causal role. The collapse in trade is presented here as a consequence, albeit one that quickly fed into the vicious downward spiral.

For today, that means the monetary response emerges the most important policy difference, a lesson truly learned and applied by the likes of Ben Bernanke and other central bankers. And for all that some groups in some countries are currently experiencing dreadful rates of unemployment, the cost in loss of jobs and human misery has been nothing like as great now as it was then. It is really encouraging to read that policymakers have not in fact been condemned to repeat the same mistakes as their forbears.

This raises the question about the Eurozone, however, the subject of the book’s final chapter by Barry Eichengreen and Peter Temin. Its conclusions are far more depressing. The authors see little room for optimism about any possible route out of the crisis – leaving the Euro is difficult and will cause turmoil, staying in is difficult and will cause political and economic instability. The only possible hope is for European governments to deliver on policies that might stimulate growth. The preceding chapter by Kris James Mitchener and Joseph Mason is somewhat sobering too, as it asks, having avoided earlier policy mistakes, how do countries now exit from their expansionary policies without disrupting the economy too much? They suggest that exit from the policies responding to the Great Depression did not occur until the 1950s; the implication is that we should be thinking on a similar timescale now.

There is much fascinating material in between these early and late chapters – this is a super collection.

I’d like to have read more about France in the 30s, as I hadn’t before realised that its gold hoarding had been larger in scale than America’s – most accounts focus on US policy. The section on the Nazis’ economic appeal is rather sobering, emphasising their ability to prioritise reducing unemployment, introduce large-scale public works, and at the same time keep wage pressure down by abolishing unions and collective bargaining.

The other country that brought unemployment down relatively quickly and realtively far in the 1930s was Britain, via a housebuilding programme – housebuilders then were able to respond quickly to low interest rates, unhampered by mad planning laws, in contrast to today. Another key difference between countries lay in the banking system, with the UK’s then in a much healthier state than the US’s. That balance has reversed now, and it is Britain’s banks that are failing to lend for new investment.

All in all, and continuing one of the themes of yesterday’s post on global governance, this book is an excellent advertisement for the relevance of economic history.