From his soapbox at the NY Times, Paul Krugman delivers a lengthy and entertaining history of the views of “saltwater” and “freshwater” economists, and laments how neither side really saw our recent financial debacles coming. Most troubling for this writer, he describes how Keynesiansim, rightly or wrongly interpreted but in either case a theory custom-made for big government, seems to be falling back into favor, although (encouraging to this writer), he surmises that the fields surrounding behavioral economics may hold better promise.
But nowhere in the article is the school of thought that did largely see this financial tsunami coming, but whose repeated warnings were largely ignored — the entire school of Austrian economics. It’s too bad, because we have a lot to learn from Ludwig von Mises, Frederick Hayek and others.
Krugman describes the gigantic mind struggle of the Keynesian and Monetarist camps, as he says “clad in impressive-looking mathematics”, each trying to out-gun each other with explanations of which levers in the economy the government should be pulling and pushing on to smooth out the business cycle. Meanwhile, the Austrians make the compelling case that it is exactly the government, mostly now via the Federal Reserve’s attempts at controlling the price of money, that causes the business cycle in the first place. There are doctoral-level tombs that get into this in great detail, such as von Mises’ “Human Action”. For an entirely more accessible version, complete with its application to recent events, check out Thomas Wood’s recent bestseller, “Meltdown”. Acknowledging the Austrian’s perspective on things would have changed the article considerably.
Years ago I spent time developing software in the fixed income departments of several major investment banks. Occasionally, the trading floor would explode in a sudden commotion like of a bunch of panicked extras in some cheesy disaster movie, with bond traders and salespeople yelling and screaming frantically. The Fed had unexpectedly cut the discount rate! (or had taken some equally earthquake-like action). Like seismologists, many players in the market would try to anticipate when these events would occur, but with some regularity, “big ones” would hit with little notice. If you happened to be positioned incorrectly, property damage (to a trader’s book) could be severe.
Since blogs are such a great place for thought experiments, why not ponder the repercussions of not having a Federal Reserve at all, as Jim Rogers, Thomas Woods and others have at one time or another? Imagine that those bond traders, salespeople and their managers were collectively the bottom line of our interest rate structures, and that were was no big Federal daddy to run home to for whatever reason. My guess is that they’d be at least a little (if not a lot) more careful with what price they put on capital, and the manner in which it was transacted.
Which brings me to another great omission in Professor Krugman’s article, that being the role of failure. Continuing the same thought experiment, if every bank knew it was NOT too big to fail, that there was no backstop for their potential mismanagement and recklessness, that would necessarily introduce an additional heap of caution into their lending practices. When your trading counterparty is deemed “too big to fail”, it sets off an entire chain of relaxation in information gathering. The mutual knowledge of needs and equally shared costs and benefits between trading partners that is required by free trade is rendered increasingly phony and precarious. Would some borrowers, who under the recent overly-lax regimes got loans (what the Austrians might refer to as “malinvestments”), no longer get them? Absolutely. But we now see that perhaps that would have been a good thing, and there is no reason to extrapolate into a scenario where lending stops entirely. Would some customers fear doing business with a bank that could fail? Absolutely. Therefore, a bank would have every reason to conduct themselves in a way that would assure their customers that they could not. This could even spawn a market for private banking insurance, the price of which would be determined by the insurance companies’ assessment of the likelihood of failure.
In 2005, WalMart scared many potential competitors and special interest groups by drafting plans to enter the banking industry. Suffice it to say, they eventually withdrew their plans. The point is, in a truly free market, driven by the profit motive, firms will always arise to meet the unmet wants of potential customers. At the same time, excess profits will always be kept in check by enabling and encouraging complete competition. “Excess profits” simply open the doors for a hungrier competitor to steal customers through better pricing.
At the height of the recent banking crisis, nearly one year ago, there were cries of bank lending potentially shutting down completely. But just because some lenders might be having trouble does not mean the need for borrowing permanently disappears. Might the extra cross-industry diversification of a “WalMart in the banking business” have influenced “banking” for the better at the margin? Would the Citibanks and Bank of Americas of the world have been forced to tweak their business models for the better? We’ll never know.
A paper entitled "No One Saw This Coming: Understanding Financial Crisis Through Accounting Models” by Dirk J Bezemer of University of Groningen identified 12 individuals (not all technically economists) who forsaw the financial and economic crisis. The abstract follows:
“This paper presents evidence that accounting (or flow-of-fund) macroeconomic models helped anticipate the credit crisis and economic recession. Equilibrium models ubiquitous in mainstream policy and research did not. This study identifies core differences, traces their intellectual pedigrees, and includes case studies of both types of models. It so provides constructive recommendations on revising methods of financial stability assessment. Overall, the paper is a plea for research into the link between accounting concepts and practices and macro economic outcomes.”
The list of individuals follows:
Dean Baker,US Wynne Godley, UK Fred Harrison, UK Michael Hudson, US Eric Janszen, US Stephen Keen, Australia Jakob Brochner Madsen, Denmark Jens Kjaer Sorenson, Denmark Kurt Richebacher, US Nouriel Roubini, US Peter Schiff, US Robert Shiller, US.
Six of these individuals are Neo-Keynesian economists (Baker, Godley, Hudson, Keen, Madsen, Sorenson), two are Austrian (Richebacher, Schiff), two are Neo-Classical economists but mavericks (Roubini, Shiller), one a sort of a combination of Austrian and Neo-Keynesian (Janszen), and one unclear (Harrison). The trouble is that none of the Austrians were technically economists and Krugman’s article was about economists.
And this apparently good record is further complicated by the fact that an argument can be made that at least Schiff among the Austrians is a permabear. Austrians seem to be always forecasting doom and gloom and as they say, “a broken clock is always right twice a day.”
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