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A hypothesis for Prof. Krugman: the transmission method was FEAR

In his recent column disagreeing with Ben Bernanke, Paul Krugman asks for an explanation as to how a financial panic could lead to years thereafter of a slow recovery. Specifically, Krugman says that he “really really wants to hear about the transmission mechanism.”

After all, the financial panic eased in 2009. And yet, outside of the very noteworthy exceptions of corporate profits generally and Wall Street bank profits specifically, the economic recovery was lethargic.

Now, to a great extent, the debate between “credit event” and “housing event” is somewhat a semantic one.  You simply don’t get a housing bubble unless there is a credit bubble to enable it. Similarly, absent a credit bubble in consumer lending for either housing (the 2000s) or appliances and furniture (the 1920s), you don’t get a big consumer downturn (see, e.g., 2001, in which consumers sailed right through a brief and shallow recession brought on in large part by a stock market bubble. See also the quick late 1980s recovery from the 1987 stock market crash).

But if you are looking for a transmission mechanism that lasted after 2009, as usual you have to look beyond narrow-minded neoclassical economy orthodoxy. Because from a behavioral point of view, the answer looks pretty simple: FEAR.

Behavioral economists have shown that people in general react twice as strongly to the fear of a loss vs. the anticipation of an equivalent gain. A good example in the everyday economy is that consumers cut back spending twice as sharply in the face of an oil price spike, as they loosen their spending in the face of a steep decline in gas prices.

It is crystal clear that the financial panic of September 2008 instilled fear in the vast mass of households. I believe that there is very good evidence that it persisted for most of this decade.

To begin with, here is a graph of consumer confidence as measured by the University of Michigan:

I have zoomed in on 2007-2015, because i want to emphasize that consumer confidence did not rebound meaningfully at all once it crashed in 2008, until about 2014. Furthermore, any time there was a whiff of renewed crisis during that timeframe, confidence plummeted, in the case of the 2011 “debt ceiling debacle,” all the way back to its bottom, but also in response to the Deepwater Horizon massive oil spill (2010), the “fiscal cliff” (end of 2012) and the GOP’s government shutdown (2013).

That, ladies and gentlemen, is fear.

Meanwhile, households didn’t just deleverage out of debt during the 2008 financial panic, but they continued to deleverage and deleverage and deleverage all the way until late 2014 — well after housing prices had bottomed (red in the graph below):

and they haven’t meaningfully increased their exposure to debt since.

Further, there was a housing boom from 1986-88 without a credit bubble. Afterward house prices declined 10% into the early 1990s:

But the below graph of the personal savings rate shows that, unlike the 1990s, when the household savings rate went into a sustained decline, as household debt levels increased (see first graph above), following the great recession, the savings rate maintained its higher level, with the exception of 2012-13 when a one year 2% rebate of Social Security withholding taxes that resulted in higher spending, which resulted in a one year decline in saving when it expired:

So, I believe a good case can be made that the “transmission mechanism” that Krugman seeks is that the trauma of the 2008 financial crisis instilled a continuing sense of fear in consumers that there might be a repeat, leading to a shunning of debt and a resulting more subdued increase in the consumption that is 70% of the U.S. economy.

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Housing: a big miss in permits with important ramifications

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A detailed look at Industrial Production during this expansion

In the past week there’s been a little highbrow relitigation of the drivers of the “Great Recession” between Paul Krugman and Ben Bernanke. Bernanke plumps for it having been a “credit event” — and as to the crisis of 2008, he is clearly correct — while Krugman says it was primarily a “housing event,” although Krugman also acknowledges that he is mainly speaking of the aftermath from 2009 onward.

Since neither the 10% decline in housing prices between 1989 and 1992, nor the NASDAQ internet bubble of 1999-2000 managed to cause the worst downturn in 75 years, my own view is that it was precisely because there was a credit bubble in the biggest asset that is owned by a majority of Americans — for which there was no financial help forthcoming to the middle class — that the effects were so longstanding. Had the government — as it did for the 1930s Dust Bowl — bought up or crammed down existing mortgages, and took repayment of the loans out of housing appreciation whenever the owners eventually sold, it is likely that the consumer rebound from the recession bottom would have been much more “V”-ish.

But neither Krugman nor Bernanke, so far as I can tell, mentions a third important reason for the slowness of the recovery: the second installment of the China shock.  Because it is crystal clear that businesses decided, once demand picked up beginning in late 2009, to move plants and hiring overseas.

This is plain when we look at how employment recovered. Services employment recovered in relatively “V”-ish fashion: two years down and three years up. Even goods employment ex-manufacturing came back in more delayed fashion, and is at 97% of peak 2007 levels. But manufacturing employment only began to turn very late and, at 92.5% of peak 2007 levels, is still far behind:

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I had written this in 2009 and it also appeared in “the new agenda.” It is a decent piece about people who saw the coming crisis pre-2007/8 and those who opposed them.

Recently, Stanford Magazine did an article on one of the University’s former law review presidents who graduated at the top of the 1964 class. The first female to hold either distinction of graduating first in her class and also as president of the school’s Law Review. Prophet and Loss. Stanford Magazine, April 2009.

“Well, you probably will always believe there should be laws against fraud, and I don’t think there is any need for a law against fraud,” Alan Greenspan

“I thought it was counterproductive. If you want to move forward . . . you engage with parties in a constructive way,” Rubin told the Washington Post. “My recollection was . . . this was done in a more strident way.”

“characterized as being abrasive.” Arthur Levitt

It would seem the three coupled with Larry Summers’s push back in Congress on the regulation of derivatives, had the problem and not Brooksley Born. Since then, all three men have suggested there should have been more regulation of the derivatives market Greenspan has called its recent collapse a “once in-a-century credit tsunami.” Called a modern-day Cassandra by Stanford Magazine, one could only wonder where we would be today if the economic and financial wizards had taken heed of Brooksley’s warning.

Short histories on CDO/CDS . . . Collateral Debt Obligations (CDO) were invented by Drexel Burnham Lambert (Milken) as a way to package asset-based securities. The CDO was tranched into similar asset backed securities of the same rating allowing investors to concentrate on the rating rather than the issuer of the bond. Ten years later, JP Morgan invented Credit Default Swaps (CDS) which was used as a mechanism to bet on a 3rd party default. In 2000, CDS were made legal with the passage of the Commodity Futures Modernization Act and any regulation of them was stymied with this bills passage. Later on, an investment firm decided to team CDS and CDO together, transferring the risk from the CDO to the issuer of the CDS, and creating a synthetic CDO. Few CDS if any and their counters naked CDS had the reserves set aside to payout a claim against a failed CDO.

It was 1994, Bankers Trust lost ~$800 million from various derivative investments. The chief losers were P&G and Gibson Greetings. Bankers Trust was formed by a consortium of banks, shedding the loan image for conducting trades. Bankers Trust was successfully sued by P&G for its losses by claiming racketeering and fraud. Bankers Trust also became known for its remarks about Gibson Greetings not knowing what Bankers Trust was doing. In 1998, Bankers Trust pled guilty to institutional fraud due to the failure of certain members of senior management to escheat abandoned property to the State of New York and other states.

In 1998, LCTM was struck by a downturn in the market when Russia defaulted on government bonds, a security LCTM was holding. To make a significant profit on small differences in value, the hedge fund took high-leveraged positions. At the start of 1998, the fund had assets of about $5 billion and had borrowed about $125 billion. When investors panicked and sold Japanese and European bonds and bought US treasuries, the spreads between LCTM holdings increased, resulting in a loss of ~$1.8 billion by August 1998. LCTM was saved by an orchestrated Fed bailout utilizing private investors.

In both cases, the history was there to call for more regulation.

It was in 1998, Brooksley Born testified to Congress about the dangers of the unregulated derivatives market referencing the LCTM losses as a recent example. It was then deputy Treasurer Larry Summers testified to Congress that Born’s desire to regulate is “casting a shadow of regulatory uncertainty over an otherwise thriving market.” Larry’s testimony set the stage for Congress to rein in the power of the Brooksley Born’s and the CFTC with the passage of Phil Gramm’s Financial Service Modernization Act of 1999 prohibiting the regulation of the derivatives market (In 2005, the revised bankruptcy laws would place derivatives outside of the laws making it the first in line to receive compensation). Wall Street and banks had clear unregulated sailing in the sea of laissez faire in 2000 with a closing of the door for debtors in 2005. It was little better than a roach motel, you could check in but you could never check out.

In 1999 in the Senate, opposition arose to the passage of the Financial Services Act in the form of North Dakota’s Senator Dorgan. An excerpt from the Senator’s speech the day before the bill was passed:

“I, obviously, am in a minority here. We have people who dressed in their best suits and they just think this is the greatest piece of legislation that has ever been given to Congress. We have choruses of folks standing outside this Chamber who spent their lifetimes working to get this done, to say: Would you just forget all that nonsense back in the 1930s about bank failures and Glass-Steagall and the requirement to separate risk from banking enterprises; just forget all that. Time has moved on. Let’s understand that. Change with the times.

We have folks outside who have worked on this very hard and who very much want this to happen. We have a lot of folks in here who are very compliant to say: Absolutely, let me be the lead singer. And here we are. We have this bill, which I will bet, in 5, 10, 15 years from now, we will be back thinking of this bill like we thought of the bill passed in the late 1970s and early 1980s, in which this Congress unhitched the savings and loans so some sleepy little Texas institution could gather brokered deposits from all around America and, like a giant rocket, become a huge enterprise. And guess what. With all the speculation in the S&Ls and brokered deposits and all the things that went with it that this Congress allowed, what did it cost the American taxpayer to bail out that bunch of failures? What did it cost? Hundreds of billions of dollars. I will bet one day somebody is going to look back at this and they are going to say: How on Earth could we have thought it made sense to allow the banking industry to concentrate, through merger and acquisition, to become bigger and bigger and bigger; far more firms in the category of too big to fail?”

Daily KOS, Senator Dorgan’s Speech, November 4, 1999 on “Gramm-Leach – Bliley Act” also known as the Financial Services Modernization Act (you can hear the 16-minute speech here or read it)

Larry Summers has been present throughout much of this change, supporting it, denigrating the opposition, and claiming his experience at D. E Shaw gave him an insider’ knowledge as to how the derivatives market works. While President of Harvard University; Larry received a letter (May 12, 2002) from Iris Mack, a new employee of the Harvard Management Company managing Harvard’s endowment funds. A Doctorate in Mathematics from Harvard and a former employee of Enron who dealt in derivative trades, she expressed concern about the trades (swaps and other complex financial instruments) being made by the funds and the lack of understanding of the trades by the traders. On July 1, Iris was called into the office of Jack Meyer, the chief manager of Harvard Management. On July 2, Iris was fired for making what Harvard Management termed as: ‘baseless allegations against HMC to individuals outside of HMC.”Ex-Employee Says She Warned Harvard of Risky Moves” Boston Globe, April 3, 2009. While Harvard Management Company claims above normal returns on its endowment funds, it has spent much of last year selling off private equity and investments to raise cash to pay for losses.

The attitude expressed by the head of the Economic Council was one of “trust me now” as I have all of the experience necessary to fix the current economic and financial problems. Instead he has promulgated the issues of the collapse by denigrating Brooksley Born’s request to Congress for regulatory power, ignoring the advice of Iris Mack at Harvard University, by consulting to D.E. Shaw (hedge fund) making ~$5.2 million as the financial engineer’s engineer following a model Buffet called Financial Weapons of Destruction, and he has been repeatedly wrong in his direction and advice to Congress and Industry.

In the game of deregulation and global efficiency, Larry Summers was its cheer leader signing off on a letter encouraging the dumping of toxic wastes in Asia at the World Bank. He helped to shepherd China into the WTO claiming:

“The agreement with China is a one-way street. China opens its markets to an unprecedented degree, while in return the United States simply maintains its current market access policies.
‘It is difficult to discern any disadvantage to the United States in passing this legislation.” Larry Summers and Senator Dorgan, Angry Bear blog.

Personality, ego, and a blind belief in the ability of the market place to dictate the proper path and the correction has gotten in front of common sense. Maybe it was time to sideline Greenspan, Summers and his protégé Geithner beliefs in favor of Born, Mack, and Dorgan’s?. The latter has shown more foresight into how today’s problems and issues were created and how to resolve them. SEC head Arthur Levitt later recanted his decision to support the Commodity Futures and Modernization Act calling it one of the worst decision he ever made.

“I certainly am not pleased with the results. I think the market grew so enormously, with so little oversight and regulation, that it made the financial crisis much deeper and more pervasive than it otherwise would have been.” Brooksley Born, Stanford Magazine, April 2009

*’The messenger wore a skirt,’ says Marna Tucker, a Washington lawyer and a longtime friend of Born. ‘Could Alan Greenspan take that?’”

run75441@ Angry Bear Blog
revised Sept. 20, 2018

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The Minsky Moment Ten Years After

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Trump Wants to Lower Drug Prices

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Weekly Indicators for September 10 -14 at Seeking Alpha

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Paul Krugman put many of his thoughts together here “What Do We Actually Know About the Economy? (Wonkish)” Basically he concludes that some economists are confused but Paul Krugman knows a lot (no one has ever accused him of being diplomatic). Of course I agree with him.
However, I am very pleased to note that I finally find one or two points of disagreement.

I’d just click the link but to try to summarize

“Macroeconomics is better than you think, microeconomics worse, and data are limited”

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in an important sense the past decade has been a huge validation for textbook macroeconomics; meanwhile, the exaltation of micro as the only “real” economics both gives microeconomics too much credit and is largely responsible for the ways macroeconomic theory has gone wrong.

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Now, the thing about IS-LM-type analysis is that using it isn’t that big a deal in normal times, but it makes some very strong predictions – predictions very much at odds with many peoples’ priors — about abnormal times. Specifically, this kind of analysis says that when there is a really big adverse shock to demand – say, from the collapse of a major housing bubble – there’s a regime change, and neither monetary nor fiscal policy have the same effects they do in normal times.

On the monetary side, old-fashioned macro says that once interest rates have been driven down to the zero lower bound, monetary policy loses traction.

[skip]

What about fiscal policy? Traditional macro said that at the zero lower bound there would be no crowding out – that deficits wouldn’t drive up interest rates, and that fiscal multipliers would be larger than under normal conditions.

The overall story, then, is one of overwhelming predictive success. Basic, old-fashioned macroeconomics didn’t fail in the crisis – it worked extremely well. In fact, it’s hard to think of any other example of economic models working this well – making predictions that most non-economists (and some economists) refused to believe, indeed found implausible, but which came true. Where, for example, can you find any comparable successes in microeconomics?

Then by microeconomics he means mostly microeconomic theory (the micro on which the Chicago school decided Macro had to be founded) and by data without theory he means accidental theory — basically assuming any parameter you estimate is stabe so any estimate reveals the law of motion of the economy.

I have mild criticisms of each of the three parts of the essay.

First on macroeconmics we are short one equation. Krugman discusses IS-LM but 1960s macro was IS-LM-Phillips curve. In any case, to complete the model one needs a model of aggregate supply. Krugman doesn’t mention the death, rebirth and re-death of the Phillips curve. 1960s macro implies that wage inflation should be increasing. The change from 10 to 3.9% unemployment with a very modest change in the rate of nominal wage inflation is a mystery. The unreversed decline in the share of labor is a puzzle (not to mention a tough problem for workers). This is also a case in which Paul Krugman in particular made predictions which were contradicted by the data. He mocks those who forecast hyperinflation in 2010, but he forecast deflation. Instead wages and prices conditnued to increase albeit very slowly. Krugman recognizes that even he didn’t appreciate 1960s macroeconomists (for example James Tobin) who stressed downward nominal wage rigitidy. This shows that off the shelf 1960s macro wasn’t a total success (largely because some of it was left on the shelf).

The current puzzle is worse. It has lead some people to use the wages taboo site:angrybearblog.com . The failure is the exact opposite of that predicted by Friedman and Lucas who argued that the correctly understood Phillips curve (as a structural causal relationship) is not a downward sloping curve but a vertical line. The data seem to think it is pretty much a horizontal line. But changing parameters are a problem for macroeconomics no matter which direction they change.

On microeconomics, Krugman briefly praises empirical micro, but then goes on to criticize the theory.

I am contrarian enough to immediately try to think of a success of a surprising prediction based on micro theory which non-economists found implausible. The prediction was popularized by Krugman who argued that the California electricity crisis would be resolved if the Federal Government put a maximum price on electricity flowing across state lines. The argument was that the crisis was created by electicity companies (including Enron) and that, if they couldn’t charge huge prices to relieve shortages, they wouldn’t create shortages to relieve. The hypothesis was based on a close reading of California’s rules for electricity pricing and the guess that that really was time for some game theory. When they finally intervened, the shortages vanished. Then Enron went bankrupt and was investigated showing that the game theory was entirely exactly correct. I think this was good micro theory. They key point was that economics 101 (really 1st semester economics 101) was inadequate because one can’t assume the wholesale electricity market is perfectly competitive. It is dominated by a few firms hence the game theory. This shows how good micro is based on sweating the details. Someone not involved in the scam had to read the regulations to figure out how they were being manipulated.

But more generally Krugman’s review of micro does not correspond to the current balance of articles and citations, because most research is now empirical. Micro theory still exists, but it doesn’t interfere with empirical work in microeconmics.

This brings me to Krugman’s critique of the accidental theorist. He considers how one would go wrong assuming correlations are constant whether or not the economy is in a liquidity trap. This is, indeed, an example of how theory is useful. The theory is very very simple, the interest paid on cash is zero and can’t be negative (except for storage costs).

I really agree entirely with Krugman that one can’t analyse data without assumptions, without a specification or prior or something. But it is a bit odd to call all identifying assumptions “theory”. This is technically true but highly misleading. Non-economists don’t perceive arguments about keeping cash in a safe as theory (although they are theory in a way). Very generally, a lot of the new empirical economics consists of looking for natural experiments– often using the states which are the laboratories of democracy as uh laboratories.

The theory is also common sense. it is immediately comprehensible to ordinary people who also find it convincing. It is very very different from the sterile theory which lead macroeconomics astray. It is also very different from the industrial organization applied game theory which was useful when discussing elecriticy shortages in California, and, finally, not at all like the theoretical work for which Krugman was awarded a Nobel memorial prize.

Finally, new empirical micro is relevant to macroeconomics. The micro distribution of changes in wages with a huge spike at zero which appeared around 2009 is very strong evidence for downward nominal rigidity. Basing macro on the assumption that people’s behavior fits micro observations of peoples’ behavior is a way to micro found which is completely unlike the project started in the 70s. I don’t think it should be dismissed as un-necessary, like the failed effort or accidental theory.

I also don’t think Krugman dismisses it. But I do think his emphasis is other than ideal

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