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).

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Mainstream macro and Minsky the maverick

I was one of the many economists who had barely heard of Hyman Minsky, still less read any of his work, before the financial crisis. One of the many who, seeking to understand, quickly devoured his [amazon_link id=”0071592997″ target=”_blank” ]Stabilizing an Unstable Economy[/amazon_link]. And found it pretty sensible. Macro isn’t my field, but there didn’t seem to be anything in that book a sensible mainstream macro person should have objected to. Should being the operative word. Because of course everyday, mainstream DSGE models in use in 2008 ruled out the very possibility of a crisis, whereas Minsky believed in their inevitability in some shape.

[amazon_image id=”0071592997″ link=”true” target=”_blank” size=”medium” ]Stabilizing an Unstable Economy[/amazon_image]

This week I’ve been reading Randall Wray’s [amazon_link id=”0691159122″ target=”_blank” ]Why Minsky Matters[/amazon_link], which is a useful and accessible overview of both what Minsky said and – as the title puts it – why it matters. I recommend the book (perhaps particularly to mainstream macro people!).

[amazon_image id=”0691159122″ link=”true” target=”_blank” size=”medium” ]Why Minsky Matters: An Introduction to the Work of a Maverick Economist[/amazon_image]

The first chapter gives an overview of Minsky’s arguments. The second chapter was to me the most interesting. It’s called ‘The Road Not taken’ and sets out the broad mainstream approach against which Minsky developed his arguments. This is the neoclassical synthesis, whose foundations were laid by John Hicks and Alvin ‘Secular Stagnation’ Hansen in the early years after Keynes’s death, then by both ‘Keynesians’ like Patinkin and Tobin and ‘Monetarists’ such as Friedman. Wray argues that these camps disagreed largely over parameter values, and that they essentially bowdlerised Keynes by ignoring his emphasis on investment, finance and uncertainty.

Debates about what Keynes ‘really’ meant in [amazon_link id=”1502423588″ target=”_blank” ]The General Theory[/amazon_link] are not all that interesting – and by the by a good reason for emphasising the importance of maths as well as words in economics. The mathematical notation is a way of enforcing logical consistency and expressing arguments with precision; the words can then explain more clearly, and introduce reality while keeping it rooted in logica and clarity. Anyway, what’s interesting about the chapter is its brief account of how finance vanished from macro, to our great cost.

[amazon_image id=”1502423588″ link=”true” target=”_blank” size=”medium” ]The General Theory of Employment, Interest, and Money (Classic John Maynard Keynes)[/amazon_image]

The later chapters of Wray’s primer set out Minsky’s views on specific issues, starting with his now-famous financial instability hypothesis: that market forces must be constrained in finance to prevent instability, but the consequent stability is itself destabilizing. The final chapter ends with some thoughts about how to proceed in the face of this paradox – in Wray’s view, tougher regulation especially of the shadow banking sector, and a smaller financial sector overall focusing on industrial investment. I agree, not least because the [amazon_link id=”0691169853″ target=”_blank” ]contribution of the sector to GDP is overstated[/amazon_link] (as Sir Charles Bean also pointed out in his recent interim report on economic statistics), and its contribution to economic welfare might well be a net negative.

This seems like common sense. I don’t entirely understand the unwillingness of the political classes to address the finance problem (despite the lobbying and campaign contributions)  – will it really take another crisis? The reluctance of people who did pre-2008 macro to ditch their human capital is entirely understandable, and I’m constantly told that anyway there has nevertheless been a lot of change in macroeconomics. Still (and to repeat, this is not my field) I’d be interested to know what proper macroeconomists think about Minsky now. If Minsky is still, as the book jacket claims, a maverick shunned by the mainstream – why?

Debt, debt, debt, debt

I’m rather late to [amazon_link id=”022627165X” target=”_blank” ]House of Debt[/amazon_link] by Atif Mian and Amir Sufi, which is recently out in paperback. It argues eloquently and persuasively that the Great Financial Crisis was not only a banking crisis but also a household debt crisis, and that the length and severity of the downturn can largely be explained by the private debt overhang. This is not the received wisdom, of course. All the policy attention has focused on the near-catastrophe of the banking meltdown, and it is terrifying even now to think how serious the economic consequences would have been if the payments systems had stopped working, as they almost did in the UK. The book acknowledges that the authorities were absolutely right to act swiftly to prevent banking meltdown, and argues that more would have been better – more in the sense of the famous ‘helicopter money’ drop advocated by Adair Turner, for one, in his recent [amazon_link id=”0691169640″ target=”_blank” ]Between Debt and the Devil.[/amazon_link]

[amazon_image id=”022627165X” 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]

However, Mian and Sufi also point out that while political campaign contributions can be shown to have led the US Congress to support bank bailouts, there was next to no household debt relief. The core of their argument is that the effects of household leverage spilled over to the whole US economy, and that writing off some of the debt owed by homeowners underwater (not because of idleness or irresponsibility but because of a macro shock) would have benefited everyone. I found their argument convincing, along with the corollary that you can not fix an excess debt problem by getting people to take on more debt. The book makes a strong case for reducing the attractiveness of debt, due in large part to the tax system. They write:

“Debt instruments lead investors to focus on a very small part of the potential set of outcomes …In a world of neglected risks, financial innovation should be viewed with some degree of scepticism. If investors systematically ignore certain outcomes, financial innovation may just be secret code for bankers trying to fool investors into buying securities that look safe but are actually extremely vulnerable.” They are also critical of the extent of the bailouts for the financial sector: “The fundamental business of a bank is lending, just as the fundamental business of a furniture company is to sell furniture. Few economist believe that the government should promote the sale of bad furniture by stepping in to protect the creditors and shareholders of a poorly performing furniture company.” This understates the externalities involved in a bank failure, of course, and – as I noted – Mian and Sufi do not condemn the authorities’ response in 2008/9.

Given where we are, they advocate instead a range of measures to reduce debt dependence in future, including levelling the tax code as between debt and equity, and encouraging the use of more equity-like financial instruments, including in lending for home purchase. They cite approvingly Bob Shiller’s suggestions for instruments to insure against macro risks (in his book [amazon_link id=”B00C791JJI” target=”_blank” ]Finance and the Good Society[/amazon_link]) and [amazon_link id=”B00HZ634AU” target=”_blank” ]Admati and Hellwig'[/amazon_link]s advocacy for far higher levels of equity as opposed to be debt to be required on banks’ balance sheets. These kinds of arguments are slowly making headway in both economics and in policy circles. But slowly. Meanwhile, what is terrifiying is the evidence of a re-inflating of the debt bubble in some economies, including the UK. Can we really be ready to risk going around the same hamster wheel again, just because the financial sector lobbies so effectively?

American exceptionalism, inequality version

Yesterday on my travels I read a short book, [amazon_link id=”0300209584″ target=”_blank” ]Income Inequality: why it matters and why most economists didn’t notice[/amazon_link], by Matthew Drennan. Professor Drennan is an urban planning expert, so having read the book’s blurb, I expected it to be a critique of the economics profession, and braced myself.

[amazon_image id=”0300209584″ link=”true” target=”_blank” size=”medium” ]Income Inequality: Why it Matters and Why Most Economists Didn’t Notice[/amazon_image]

It ended up not being what I expected. In fact, the book repeats Raghuram Rajan’s argument in [amazon_link id=”0691152632″ target=”_blank” ]Fault Lines[/amazon_link] – that low-income Americans went into debt to increase their consumption levels as well as buy homes, keeping up somewhat with the rich thanks to easy credit. One of the central chapters has a long appendix reporting some econometric work claiming to establish causality between higher income inequality and higher debt. However, it is not sufficiently detailed to be able to assess the empirical work, while too technical to be of interest to the general reader. So the central section of the book is a bit odd.

It’s a fair cop to say the generality of the economics profession did not pay enough attention to rising income inequality. The biggest lasting impact of Piketty’s [amazon_link id=”067443000X” target=”_blank” ]Capital in the 21st Century[/amazon_link], and the work with Atkinson and Saez on which it was based, will turn out to have been consciousness raising. Nobody is ignoring it now. However, there are now several important books on this subject: as well as [amazon_link id=”0691152632″ target=”_blank” ]Faultlines[/amazon_link] and [amazon_link id=”067443000X” target=”_blank” ]Capital in the 21st Century[/amazon_link], Mian and Sufi’s [amazon_link id=”022608194X” target=”_blank” ]House of Debt[/amazon_link], Atkinson’s [amazon_link id=”0674504763″ target=”_blank” ]Inequality[/amazon_link], Francois Bourguignon’s [amazon_link id=”069116052X” target=”_blank” ]The Globalization of Inequality[/amazon_link] and Branko Milanovic’s forthcoming [amazon_link id=”067473713X” target=”_blank” ]Global Inequality: a new approach for the age of globalisation[/amazon_link]. I didn’t find much novelty in Drennan’s [amazon_link id=”B017DNAI3A” target=”_blank” ]Income Inequality[/amazon_link], although it is at least a short introduction.

Above all, though, my reaction to the book wasn’t that it was about economics, more that it was about America. We do tend to forget that inequality is greater in the US than most other OECD countries, and has risen more. Perhaps it can act as the canary in the cage for the rest of us, but a good part of the story lies in US politics and institutions. After all, just look at the Republican primary contenders.

OECD income inequality

OECD income inequality

Bankrupt banks

I’ve been browsing through a new book, [amazon_link id=”0817918841″ target=”_blank” ]Making Failure Feasible: How Bankruptcy Reform Can End Too Big to Fail[/amazon_link], edited by Kenneth Scott, Thomas Jackons and John Taylor. The book is the product of a Hoover Institution project formed in 2009 to address concerns about the moral hazard that would result from bank bailouts. The project quickly concluded that a bank ‘resolution’ procedure was vital, and proposed a Chapter 14 of the US Bankruptcy Code to create a mechanism ready to be applied to restructure or liquidate any large financial institution of systemic importance that gets into trouble.

[amazon_image id=”B015M9SQYK” link=”true” target=”_blank” size=”medium” ]Making Failure Feasible: How Bankruptcy Reform Can End Too Big to Fail[/amazon_image]

The book spells out the rationale for a bank resolution mechanism and explains in more detail how the Chapter 14 would work. It argues that the proposal would make it easier for US banks to comply with the ‘living will’ requirement of the Dodd-Frank Act. As the book notes in a later chapter, however, a domestic resolution procedure, even for the US, is only a partial answer for banks that are of global importance. The Bank of England and IMF have said there are 16 of these institutions. And there is, the cross border chapter here says, no consensus internationally about the right approach to bankruptcy. So if there is another global financial crisis in the short term, we will be in huge trouble again.

Still, it is good to see that people have been working on detailed bankruptcy proposals – although the detail will be of interest mainly to banking specialists, which I’m not. Let’s hope the regulators get on to the global complexities soon.