John Quiggin is, as usual, Brilliant.
John Quiggin provides an excellent discussion of macroeconomics. It is much too good to summarize. Just click the link and read.
Paul Krugman is also (as usual) brilliant. In particular, I fear he understands the sociology of the profession.
I have some comments on Quiggin.
This is, as usual, brilliant. I can think of a few things to add.
1) the claim that medium and long run outcomes are determined by tastes and technology does not imply that there is a unique long run equilibrium growth path. This would follow if technology were exogenous, but, of course, it isn’t. It is standard in business cycle theory to assume that technological progress is exogenous, but really believing that it is exogenous is much crazier than believing in rational expectations and such. In growth theory it is conventional to attempt to model technological progress. This is enough for equilibrium to be indeterminate and for demand side policies to have permanent effects.
2) There was a rather large literature on coordination failures which cause fluctuations (you know Benhabib and Farmer and such like). There was nothing wrong with this literature as math of fun theory. It seems to have vanished. It just wasn’t true in 2007 that if you want to insist on rational expectations then the available choices are new classical vs sticky price models in which long run averages were as in new classical models.
3) Actual general equilibrium theory did not stagnate from 1950 on. Actual general equilibrium theorists studied models with incomplete markets in which equilibria can be indeterminate, sunspots can affect outcomes and equilibria are generically not constrained Pareto efficient.
4) Persistent fluctuations due to aggregate demand were renamed “hysteresis” by Blanchard and Summers in 1986. European data already massively rejected the not yet developed old new Keynesian models. This paper was considered to be relevant to a relatively minor field (the study of strange countries which aren’t the USA) and ignored in mainstream macroeconomics eg by Blanchard and Quah in 1987. The study of the strange unusual case of developed countries other than the USA didn’t even remain central to the modelling of European macroeconomies by European central banks.
All four points imply that the very widespread conviction among macroeconomists that long run outcomes are unique and determined by exogenous variables had no basis in theory. All over the place highly mathematical theory showed how that needn’t be true (typically theory based on extreme over use of the assumption of rational expectations do a degree which would make Lucas blush).
The assumption of a unique exogenous long run growth path absolutely does not follow from the D, S, G or E parts of DSGE. It is a separate assumption –a methodological a priori not an implication of other standard assumptions. I think you have explained why. If equilibrium is indeterminate, then economists can’t design optimal plans and economists are reluctant to admit this.
In contrast, it is possible (by extreme abuse of the assumption that the world is in Nash equilibrium) to write down models in which economic agents magically know which equilibrium they are in and in which there are Nash equilibrium with possible persistent depressions. The assumption of rational expectations makes no sense at all when there are multiple Nash equilibria. However, this does not reliably embarrass game theorists. The calculations required by agents in DSGE models with a unique equilibrium are obviously completely alien to actual people. I don’t see an intimate connection between multiple long run growth paths and people having to rely on rules of thumb. Real people rely on rules of thumb even in situations with a unique equilibrium (say a zero sum game with a 5 by 5 game matrix). Imaginary economic agents can know which of a continuum of Nash equilibrium they are in (solving the models feels about the same).
I haven’t seen any evidence that “leading” NeoKeynesian, NeoClassical, and Austrian economists determined what caused the financial crisis. It should be noted, the global economy (or a large economy) is a huge multidimensional puzzle, where all the pieces fit together perfectly.
There seems to be three major factors that caused the financial crisis:
1. The U.S. was running increasingly larger trade deficits, since around 1980. In 2005, the U.S. trade deficit reached 6% of GDP or $800 billion. The U.S. was consuming $800 billion more than producing in the global economy, while at full employment (less than 5% unemployment rate) in 2005.
Foreigners had to sell their goods more cheaply and lend their dollars more cheaply (including through interest rates, currency exchange rates, and inflation) to keep the virtuous cycle of consumption-investment going (contributing to larger current account deficits and capital account surpluses).
However, U.S. consumers had diminished marginal utility (the opposite of pent-up demand), and dollars weren’t “recycled,” to U.S. consumers (foreigners bought U.S. Treasury bonds and the federal government spent those dollars, or reduced budget deficits, rather than “refunding” enough of those dollars back, to consumers, in the form of tax cuts)..
2. In the housing market, Congress created a giant social program, it believed it didn’t have to pay for, along with promoting moral hazard and preserving “too-big-to-fail.” If Congress began tightening lending standards when the Fed began the tightening cycle, in 2004, the financial crisis and severe recession may have been averted or lessened.
3. We had a severe oil shock, because of “Peak Oil.” By mid-2008, oil reached about $150 a barrel (the Fed deserves a lot of credit for beginning an easing cycle, in Sep 2007, while oil prices were rocketing, although the Fed caused the recession initially by keeping a restrictive stance too long with contractionary fiscal policy).
peaktrader –
Re: your Point 2. By the beginning of 2004, the inflation adjusted Case-Shiller housing index was already more than 9 standard deviations above the ’53 to 2000 mean.
That would have been closing the barn door after the horses had already departed.
FWIW, It peaked in Q4 ’05 at 15.6 Std Devs above the avg.
Even now, after crash-bouncing off the mean value [124] , it’s at a value [150.21] that, except for the bubble, would be an all time high.
What does that bode?
JzB
Nation upon nation investing ALL available cash in fraudulent sub-prime mortgage backed securities along with overvalued new financial products-CDS’s, etc.. They looked “too good to be true”, and THAT’S just how good they were.
Not to mention the illusion of insurance for the derivatives, which proved to be as empty of real equity as the terrible loans forming the base of the derivatives. Blaming it all on trade imbalances strikes me as an effort at deflection. “You gonna believe me or your own eyes?”
Jazzbumpa, the homebuilding boom and lax lending standards were from 1995-07. Paul Krugman stated the housing boom was needed after 2000 to lift GDP growth (to replace the tech investment boom).. However, lending standards should’ve been controlled, similar to monetary policy (by the Fed).
Bush Administration Tried to Reform Freddie and Fannie Five Years Ago
February 19, 2009
“Fannie Mae and Freddie Mac “accelerated their imprudent behavior after we attempted to regulate them. They bought almost as much mortgage debt from 2005 through 2008” as they bought in their first 30 years of their existence.
in 2003, when we sent our first members of the Cabinet up to talk about this on Capitol Hill, Barney Frank had a hearing in which they basically beat up everybody we sent up there in pretty vociferous language.
in fact, we moved aggressively in 2004 to regulate Fannie and Freddie, actually got a bill through the Senate Banking and Finance Committee only to have it filibustered by [Sen.] Chris Dodd.”
http://www.cnsnews.com/news/article/bush-administration-tried-reform-freddie-and-fannie-five-years-ago
Michael Bloomberg, former Mayor of New York City, stated:
“It was not the banks that created the mortgage crisis. It was, plain and simple, Congress who forced everybody to go and give mortgages to people who were on the cusp.
Now, I’m not saying I’m sure that was terrible policy, because a lot of those people who got homes still have them and they wouldn’t have gotten them without that.
But they were the ones who pushed Fannie and Freddie to make a bunch of loans that were imprudent, if you will. They were the ones that pushed the banks to loan to everybody. And now we want to go vilify the banks because it’s one target, it’s easy to blame them and Congress certainly isn’t going to blame themselves.”
****
“By 2007, 55 percent of all loans made by Fannie and Freddie had to be “affordable.” By June 2008, there were 27 million subprime housing loans outstanding (19.2 million of them directly owed by government or government-sponsored agencies), with an unpaid principal amount of $4.6 trillion.
Almost 50 percent of all mortgages outstanding in the United States in 2008 were subprime or otherwise deficient and high-risk loans.
Two-thirds of these mortgages were on the balance sheets of government agencies, or firms required to buy them by government regulations.”
http://angrybearblog.strategydemo.com/2012/03/subprime-and-crisis.html St. Louis Fed research
http://angrybearblog.strategydemo.com/2008/07/fannie-mae-and-freddie-mac-rock-bottom.html
http://angrybearblog.strategydemo.com/2008/09/fannie-mae-and-freddie-mac-broader-view.html
http://angrybearblog.strategydemo.com/2008/09/fannie-and-freddie-capital-requirements.html
http://angrybearblog.strategydemo.com/2008/10/2005-federal-housing-finance-reform-act.html ( More background 2005 )
http://angrybearblog.strategydemo.com/2011/01/fannie-and-freddie-and-william-black.html
http://angrybearblog.strategydemo.com/2013/08/facing-fannie-freddie-facts.html
See page 13 of this pdf at:
http://www.fhfa.gov/webfiles/2919/Lockhart_Speech_to_National_Association_of_Real_Estate_Editors-06-18-09.pdf
In the first quarter of 2009, Private Label mortgages numbered 13% of the total mortgages and 42% of the Seriously Delinquent mortgages.
In the first quarter of 2009, Fannie Mae and Freddie Mac mortgages numbered 57% of the total mortgages and 22% of the Seriously Delinquent mortgages.
If you read the news in 2007, 2008, and 2009 you already knew this, at least to some degree. Unless you chose not to know. Perhaps because government is always wrong, and private enterprise is always correct.
This is not to say that Fannie Mae and Freddie Mac did not make mistakes. They did. They tried to compete in a residential mortgage market terribly distorted by out and out fraud. Then they bought mortgage backed securities from banks without examining every single underlying mortgage for fraud.
Then in September 2011 Bloomberg News took note of lawsuits by the FHFA:
http://www.bloomberg.com/news/2011-09-03/jpmorgan-bofa-among-17-banks-sued-by-fhfa-over-196-billion-in-securities.html
“The Federal Housing Finance Agency, on behalf of Fannie Mae and Freddie Mac, filed 17 lawsuits yesterday in New York state and federal courts and in federal court in Connecticut. The FHFA accuses the banks of misleading Fannie Mae and Freddie Mac about the soundness of the mortgages underlying the securities.”
While I don’t deny the foolishness of the subprime lending frenzy, I think it has been pretty well established that we could have recovered from that, by itself, without a financial collapse (compare the S&L collapse earlier). However, the casino-like “investments” that sprung from the real estate bubble were the real sins of the banks and financial houses. That is what caused the collapse of the economy.
Amazing post, prof
Dan, actually, it went like this:
Borrowers were able to to buy houses they couldn’t really afford, and lenders were able to make lots more money on more loans.
Lenders knew they’d be bailed-out by “too-big-to-fail, which they were with TARP, and knew the music would eventually stop.
Do you really believe banks would lend money to people with no down payment and no income without government encouragement and support?
Myth busted.
JackD, you’re in denial. Congress not only created the moral hazard, it promoted it Most borrowers and lenders behaved rationally, not foolishly. Of course, the policy was foolish, and Congress was outwitted (I guess, politicians like Dodd and Frank thought they were so clever, lol).
Au contraire, PeakTrader. You have ignored the casino built on the rotten real estate market. It magnified things beyond control. That is what called too big to fail into being. It is you, I think, who is in denial, at least if you are advocating a return to unregulated derivative speculation. I don’t know if you are, or not, but I do note that you didn’t bother to discuss it one way or the other.
JackD, government was the big dealer in the “casino built on the rotten real estate market.” Some regulations are good and some are bad. Which ones are you talking about?
It should be noted, the housing boom wasn’t all bad. Entire new neighborhoods were created and millions of people, who otherwise couldn’t afford to buy a house, were able to buy them.
And, when they failed to make mortgage payments, they were able to live in them for free, for a year or more, while others managed to keep their houses.
If Congress began to tighten lending standards in 2004, when the Fed began tightening the money supply, the bust in the housing market and economy may have been averted, and many more homeowners would’ve been able to keep their homes.
Peak:
This:“millions of people, who otherwise couldn’t afford to buy a house, were able to buy them.” is simply not true in the sense the poor and minorities were the major cause of the collapse of TBTF and Wall Street. Look to Alt-A mortgages which went to middle and upper income brackets. Even Heritage acknowledges such:
“In 2001, newly originated subprime, Alt-A, and home equity lines (second mortgages or “seconds”) totaled $330 billion and amounted to 15 percent of all new residential mortgages. Just three years later, in 2004, these mortgages accounted for almost $1.1 trillion in new loans and 37 percent of residential mortgages. Their volume peaked in 2006 when they reached $1.4 trillion and 48 percent of new residential mortgages. Over a similar period, the volume of mortgage-backed securities (MBS) collateralized by subprime mortgages increased from $18.5 billion in 1995 to $507.9 billion in 2005.”
Alt-A loans typically went to people with good credit and high incomes except in this case the amounts and increasing use of them was perpetuated with increased fraud by originators such as Wachovia, Washington Mutual, etc. They were sold in tranched MBS/CDO and insured through the CDS by AIG etc. so they could be rated at AAA by Moodys and S&P. G&S played the game well and counter insured them with naked CDS.
Congress doesn’t tighten lending practices, the banks and the Fed do.
The government wasn’t buying and selling credit default swaps that were simple gambles on the financial health of portfolios in which the gamblers had no direct financial interest or ownership. Then AIG “insured” these transactions even though the “insureds” had no insurable interest in the subject matter. It was analogous to you taking out an insurance policy on my life even though there is no relation between us. The law doesn’t allow that in life insurance and it shouldn’t in CDS’s either. The financial crisis resulted from the coming to term of all those bets and the failure of the “insurance” to cover due to virtually non existent reserves. Under Glass- Steagal (sp?) that couldn’t have affected the banks because they wouldn’t have been allowed to play in that casino with depositor’s money.
JackD, where do you think the money came from to make the loans? A huge portion of it came from Fannie and Freddie. Lenders would lend and loans would be packaged into mortgage backed securities, which Fannie and Freddie bought, along with others. So, money was recycled to make more loans. With the exception of Fannie and Freddie, risk was diversified, on a global scale.
Actually, Fannie and Freddie bought mortgages and sold mortgage backed securites to make more loans.
PeakTrader, I’m not talking about the loans themselves. I’m talking about the bets on the loan packages by those who didn’t even own them; just bet on them. As it turned out, the loans themselves were not as big or bad a problems the CDS’s.
JackD, too many risky loans was the problem, not betting on them. You can buy a $5 stock or security for $10 and it may rise to $20. However, the question is why are there so many $5 stocks or securities, in the market, not whether they’ll rise or fall?
run75441, your assumptions and interpretation of the data are false. The homeownership rate rose from 64% in 1994 to 69% in 2005 (and it’s now below 65.5%). There were booms in homebuilding, lending, refinancing, and home improvements. Congress created and facilitated the conditions that made the booms unsustainable.
Peak:,
There was no need for Congress to establish additional laws other than opening up the spigot on equity removal which I alluded to below which banks did in the late nineties. A similar collapse happened in the late nineties with LTCM which was largely driven by financial engineering and the speculative planning which could not be unraveled in the end. Again in the late nineties the seeds were sowed with Greenspan, Rubin, Levitt, Summers, Geithner, etc. pushing for the repeal of Glass-Steagal and alteration of the Bank Holding Company Act (1999) after already increasing the limits on Section 20 up to 25%. It would be good if you established the history of the collapse before coming out hear and spewing your unsubstantiated history and conjecture. There was no need for Congress to do more as the wheels of the eventual collapse were already in motion.
Indeed, the increase in home ownership came above the input of equity looking to buy and foreign moneys looking for safe haven while the Fed Rates were low and Greenspin signaled there would be no increase in Fed Rates in the near term. Couple this with Clinton and Bush’s input of funding and the perfect storm was created. There was no need for Congress to do more for banks as they already had the ability to set up tranched MBS, trade in derivatives such as CDS and naked CDS, and set the loan guidelines as Mozilla did and well before the collapse. LTCM was the early on signal what could happen.
Jack is correct when he cites CDS as the prime suspect which is a part of the derivatives market and from which we also rescued AIG from collapse. Goldman Sachs gamed it well and ~$10 billion at one occurrence funneled directly to them through AIG. Where there was legislation needed was with the derivatives market. Brooksley Born called for it, Senator Dorgan campaigned for it before Glass Steagall was repealed, and Iris Mack suffered the consequences of challenging investments in the derivatives by Harvard while Summers was the president. Tranched MBS insured by CDS and countered with naked CDS and rated AAA were the issue. Peak, you could not untangle a tranched MBS and sort out the assorted CDS insuring them in your lifetime.
run75441, you just can’t accept the root cause of the financial crisis was too many risky loans, facilitated with the encouragement and support of Congress.
Asset markets will rise and fall, and there can be a huge fall in asset prices with a mild recession, e.g. 2001.
If lending standards began to rise in 2004, when the Fed began tightening the money supply, the result woud’ve been a more sustainable and optimal housing market, with much less spill-over into the macroeconomy.
Peak:
You can not accept the prime cause of the collapse was too many risky Alt-A loans made to higher income people requiring little in the way of down payment. This in itself would not be the cause for the collapse of Wall Street and TBTF except for the tranching of MBS overrating these loans as less risky through the rating agencies such as Moodys and S&P. That both rating ratings were not brought up on criminal charges due to fraud is astonishing. GS bet long and short utilizing CDS and naked CDS when AIG insured the tranched MBS and then they turned around and collected $billions when AIG collapsed as well as other firms. It is time for the Fed to revoke GS bank status and return them to an investment firm. After all why should Main Street finance their cheap loans?
You have gone from blaming the CRA and subprime to minorities to generalizations of the causes of the collapse. Many homeowners did not have to refinance to take out equity. All they needed to do is get a second mortgage at a variable rate. They took as much money as they could and blew it in most cases.
2001 recession came about as a result of the Fed increasing the Fed Rate. When Greenspin realized what he did he crashed the Fed Rate down to 1-1/4% in 2002 from a high of 6-1/2% in 2000. Greenspin blew up the economy with his Fed Rate increases when all he had to do was increase reserves to slow down the Dot.Com bubble. Similar can be said for the crash in 2007/8.
You are explaining things after the fact and cobbling on to mine, Jacks, and others explanations. I hope you are a good Cardiologist because your understanding of the 2001 and 2008 recessions in not sound. I still want to hear how Medicare aids those who are poor.
It should be noted, given the homeownership rate rose from 64% to 69%, and then fell below 65.5%, a large portion, if not most, of the home loans may have been categorized as “high-risk” loans.
Also, many homeowners refinanced at lower rates and extracted some equity (e.g. for home improvements, spending for other goods & services, or traded-up for more expensive homes). So, many of those mortgages eventually became “underwater.”
Peak Trader’s narrative fails to explain why the real estate markets of countries around the world collapsed nearly simultaneously, in favor of promulgating a tired mantra from the American “conservative” movement that demands that blame for the failure of the Market as God lies with government meddling and ultimately the sinfulness of democracy.
I thought Barry Ritholtz nailed this on his blog and in his columns in the Washington Post titled “The Big Lie.” Peak Trader appears to be a dead ender clinging to an explanatory narrative that is not based in verified fact but in the emotional attachment to a just-so story that defines “conservative” identity.
http://www.ritholtz.com/blog/2011/11/the-big-lie/
http://www.washingtonpost.com/business/what-caused-the-financial-crisis-the-big-lie-goes-viral/2011/10/31/gIQAXlSOqM_story.html
Ritholtz notes the government’s biggest failure was allowing Fannie and Freddie to participate in the private mortgage sector’s Tulip-manic mortgage swindle just as it was unwinding.
http://delong.typepad.com/sdj/2014/01/tuesday-around-the-internet-robert-waldmann-on-john-quiggin-on-old-old-old-new-new-old-and-new-new-keynesianism-january.html