Where are we going and when is this interregnum going to end? That’s the question on everyone’s lips.
Today I have three scenarios and a coda. Caveat lector: I don’t know which of the scenarios is most likely, but I do endorse the coda as I have few things since I’ve started writing “Adam Smith, Esq.” But it’s unfair reading ahead.
The three scenarios are by now relatively familiar, but they were aptly summarized a couple of days ago in the WSJ by David Wessel in “Long Odds?” The scenarios are:
V: The optimistic scenario. Here’s the case for, and the description of, that:
The late Victor Zarnowitz, a student of the business cycle, had a rule: “Deep recessions are almost always followed by steep recoveries.”
“In deep recessions,” says Michael Mussa of the Peterson Institute for International Economics, “there is usually a growing sense of gloom as the recession deepens.” Then the forces that triggered recession — say, plunging home prices — abate. The adrenaline of tax cuts and government spending kicks in. With inventories so lean, the slightest uptick in demand prompts a sharp increase in production, and the natural dynamism of capitalism reasserts itself.
He gives it odds of 15%.
Big D: The disaster scenario. Some think we’re already there:
“This is a Depression-sized event,” says economic historian Barry Eichengreen of the University of California at Berkeley, citing the global decline in industrial production and world trade. The big difference: In 1929, governments dithered, or worse. In 2009, they’ve rushed to the rescue.
The risk of the Big D is that the Fed (and the Bank of England, and the Bank of Japan) have already put the monetary pedal to the metal, and so far there’s no convincing evidence that we’re pulling out.
20% odds.
L:
This is Japan’s famous “lost decade” of the 1990’s, with an appalling annual “growth” rate of 0.5%. (Given the US’ population growth, that would mean negative per capita growth.) The danger for us about an L “recovery” (they’re not really recoveries) is that, according to the IMF, recessions caused by financial sector crises typically take longer to recover from.
There are also structural temptations to do nothing dramatic in an L recovery:
An unfolding depression could scare Congress to act boldly, but the L is less ominous — and perhaps more likely as a result. There would be months when the economy appeared to be strengthening so the temptation to wait-and-see would be strong.
Odds: 55%.
If you’ve been keeping score at home, that adds up to 90%, so throw another 10% at the “U.”
Now, I’m about to tell you that everything you’ve just read is such rampant speculation that you may have wasted your time.
For this I’m indebted to John Kay writing a few days ago in the Financial Times about “how economics lost sight of the real world.” I’m a regular follower of his, but in case you’re not here’s a brief excerpt from the FT’s bio page about who Kay is:
John Kay has been writing a column on economics and business since 1995. His academic career has included chairs at London Business School and Oxford University; he is currently a visiting professor at the London School of Economics. He also had a career in the policy world which established the Institute for Fiscal Studies as one of the most respected think-tanks and a business career in which he established, developed and sold a substantial consulting firm and in which he has been a non-executive director of Halifax plc and several companies.
Kay begins his column by understating the obvious: “The past two years have not enhanced the reputation of economists.” Among other failures, economists–and, I might add, financial engineering geniuses–failed to identify the structural weaknesses in the explosion of asset-backed securities (driven by greed for bonuses and commissions rather than discovery of a way to make a package of 1,000 mortgages more intrinsically valuable than it would be to hold all of them individually), failed to predict the current crisis, and now that we’re in the midst of it fail to agree on how the future will unfold and what policies are most suited to bringing this to an end as quickly and prudently as possible.
Indeed, he notes that the economists whose names are bandied about most frequently today are long since dead: Keynes, of course, but also Hyman Minsky, who taught at Brown, Berkeley, and Washington University, and whose primary contribution to economic theory was his prediction that during prosperous times, two classes of borrowers would spontaneously develop alongside those conventional borrowers who could fund interest payments and repay principal out of normal cash flow.
The first type of unconventional borrower were “speculative borrowers,” who could pay interest out of normal cash flow, but not principal: Thus needing to roll over and refinance their debts at regular intervals. This is bad enough, but the second and even more explosive type of borrower were “Ponzi borrowers” who couldn’t even service income obligations out of cash flow, but only out of taking on additional liabilities.
You can readily see how this leads to tears: Minsky nicely calls it a “deviation-amplifying system.” At some point, realists begin to question the viability of the Ponzi borrowers, who at that “Minsky moment” are certain to collapse almost in a flash. The simultaneous halt and then reversal in the rise of asset prices immediately catches up with the speculative borrowers who find themselves unable to refinance their obligations as they come due, and the subsequent collapse of asset prices leads to a seizure of the credit system even for the conventional borrowers whose creditworthiness may be perfectly sound.
In any event, Kay’s point is an even larger one:
Since the 1970s economists have been engaged in a grand project. The project’s objective is that macroeconomics should have microeconomic foundations. In everyday language, that means that what we say about big policy issues – growth and inflation, boom and bust – should be grounded in the study of individual behaviour. Put like that, the project sounds obviously desirable, even essential. I confess I was long seduced by it.
So, Professor Kay, was I: Indeed, the primary reason I chose to major as an undergraduate in economics was that I saw it at the time as a discipline in transition, if not in positive disarray. (The second reason was that it happened to be an exceptionally strong academic department at the university I attended, and it still is, turning out such name brands as Ben Bernanke, Alan Blinder, and Paul Krugman.)
But the Grand Project of economics–the equivalent of physics’ search for the Unified Field Theory [of everything]–has failed abysmally. As Kay aciduously points out, the only people who believe otherwise are professional academic economists themselves:
Most economists would claim that the project has been a success. But the criteria are the self-referential criteria of modern academic life. The greatest compliment you can now pay an economic argument is to say it is rigorous. Today’s macroeconomic models are certainly that.
But policymakers and the public at large are, rightly, not interested in whether models are rigorous. They are interested in whether the models are useful and illuminating – and these rigorous models do not score well here.
The problem inheres in the very core assumptions of extreme human rationality and unchallengeable market efficiency. Once you abandon those assumptions, or even once you permit doubts about their universality to infect your economic model, the project becomes insuperable:
Any other theory would have to account for the evolution of individual beliefs and the advance of human knowledge, and no one imagines that there could be a single theory of all human behaviour. Not quite no one: a few deranged practitioners of the project believe that their theory really does account for all human behaviour, and that concepts such as goodness, beauty and truth are sloppy sociological constructs.
But these people discredit themselves by opening their mouths.
Call me a contrarian (I have never been delusional about being an academic economist; indeed I had the good sense before college graduation to abandon any notion of pursuing a Ph.D. in the field since I saw how fabulously detached from reality its “rigor” made it), but I actually enjoy the uncertainty introduced by the frays and tears in the assumptions of human rationality and market omniscience. Without some irrationality and some market failures, where would we find so many of our opportunities for profit?
In the end, economics may be closer to engineering or medicine than to physics:
[T]he knowledge we can hope to have in economics is piecemeal and provisional, and different theories will illuminate different but particular situations. We should observe empirical regularities and – as in other applied subjects such as medicine and engineering – we will often find pragmatic solutions that work even though our understanding of why they work is incomplete.
Kay concludes by quoting (who else?) Keynes, who wrote that an understanding of economics was not to be given to “those whose gift mainly consists in the power to imagine and pursue to their furthest points the implications and prior conditions of comparatively simple facts which are known with a high degree of precision.”
Rather, comprehension of economic events depends on intuition, a wide-ranging exposure to and familiarity with facts and with human behavior, and only then a dose of reason and rationality. Perhaps it was this reality that informed the famous German physicist Max Planck’s decision in “gymnasium” to pursue physics rather than economics because economics was too hard.
