Monday, July 27, 2009

“Up to a point, Your Majesty”

“No One Saw it Coming” …

When Queen Elizabeth II visited the London School of Economics in November 2008, “she asked Professor Luis Garicano, of the economics' management department, about the origins of the credit crisis, saying: "Why did nobody notice it?". Prof Garicano told the Queen: "At every stage, someone was relying on somebody else and everyone thought they were doing the right thing." The Queen described it as "awful". Prof Garicano said afterwards: "The Queen asked me: 'If these things were so large, how come everyone missed them?'". Now the Queen has been sent a letter by professor Tim Besley of LSE (a member of the Bank of England Monetary Policy Committee) and other eminent economists, explaining how "financial wizards" failed to "foresee the timing, extent and severity" of the economic crisis. The letter ends: "In summary, your Majesty, the failure to foresee the timing, extent and severity of the crisis and to head it off, while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole." (The Observer, 26 July 2009).

“The idea that ‘no one saw this coming’... has been a common view from the very beginning of the credit crisis, shared from the upper echelons of the global financial and policy hierarchy and in academia to the general public”: Dirk J. Bezemer, of Groningen University (“No One Saw This Coming": Understanding Financial Crisis Through Accounting Models, 16 June 2009). Bezemer provides abundant examples: “Few, if any people anticipated the sort of meltdown that we are seeing in the credit markets at present” (former USA Treasury Minister Robert Rubin, at a session at the Brookings Institution in Washington, 14 March 2008). On 9 December 2008 Glenn Stevens, Governor of the Reserve Bank of Australia commented on the “international financial turmoil through which we have lived over the past almost year and a half, and the intensity of the events since mid September this year”. He went on to assert: “I do not know anyone who predicted this course of events”. On 9 April 2009 Nout Wellink – chairman of the Basel Committee that formulates banking stability rules and Dutch representative at the European Central Bank - told his audience that “[n]o one foresaw the volume of the current avalanche” (Bezemer, cited).

Predictably economists get a rough treatment, in connection with the global financial crisis, also in a major review of “The state of Economics”, published by The Economist of 18 July 2009. “There are three main critiques: that macro and financial economists helped cause the crisis, that they failed to spot it, and that they have no idea how to fix it.”

… But Some Knew Better Than Others

Tim Besley and his colleague signatories of the letter to the Queen can speak only for themselves. Undoubtedly lots of economists in high places made utter fools of themselves for views that were so spectacularly falsified by the crisis. In February 2005 Alan Greenpan asserted to the US House Financial Services Committee that "I don't expect that we will run into anything resembling a collapsing [housing] bubble, though it is conceivable that we will get some reduction in overall prices as we've had in the past, but that is not a particular problem."(quoted by Bezemer). In its Report on “Financial Globalization: A Reappraisal” (August 2006) the IMF confirmed its established view that “there is little systematic evidence to support widely cited claims that financial globalization by itself leads to deeper and more costly crises” (p.1). Anatole Kaletsky (FT 13 November 2008) wrote of “those who failed to foresee the gravity of this crisis - a group that includes Mr King, Mr Brown, Alistair Darling, Alan Greenspan and almost every leading economist and financier in the world.”

Bezemer (who provides the above quotes and more) shows that, on the contrary, “it is not difficult to find predictions of a credit or debt crisis in the months and years leading up to it, and of the grave impact on the economy this would have - not only by pundits and bloggers [absit inIuria verbis!], but by serious analysts from the world of academia, policy institutes, think tanks and finance.” He list a dozen, for starters.

Anticipations of the Housing Crisis and Recession

Dean Baker, US co-director, Center for Economic and Policy Research. “ …plunging housing investment will likely push the economy into recession.” (2006).

Wynne Godley, US Distinguished Scholar, Levy Economics Institute of Bard College [1970–1994 Director of the Department of Applied Economics, University of Cambridge;
1956–1970 The Economic Section of the H.M. Treasury (Deputy Director from 1967): and professional oboist ]. “The small slowdown in the rate at which US ousehold debt levels are rising resulting form the house price decline, will immediately lead to a …sustained growth recession … before 2010”. (2006). “Unemployment [will] start to rise significantly and does not come down again.” (2007).

Fred Harrison, UK Economic commentator. “The next property market tipping point is due at end of 2007 or early 2008 …The only way prices can be brought back to affordable levels is a slump or recession” (2005).

Michael Hudson, US professor, University of Missouri “Debt deflation will shrink the “real” economy, drive down real wages, and push our debt-ridden economy into Japan-style stagnation or worse.” (2006).

Eric Janszen, US investor and iTulip commentator. “The US will enter a recession within years” (2006). “US stock markets are likely to begin in 2008 to experience a “Debt Deflation Bear Market” (2007).

Stephen Keen, Australia associate professor, University of Western Sydney. “Long before we manage to reverse the current rise in debt, the economy will be in a recession. On current data, we may already be in one.” (2006).

Jakob Brøchner Madsen & Jens Kjaer Sørensen, Denmark professor & graduate student, Copenhagen University. “We are seeing large bubbles and if they bust, there is no backup. The outlook is very bad” (2005)” The bursting of this housing bubble will have a severe impact on the world economy and may even result in a recession” (2006).

Kurt Richebächer, US private consultant and investment newsletter writer “The new housing bubble – together with the bond and stock bubbles – will invariably implode in the foreseeable future, plunging the U.S. economy into a protracted, deep recession” (2001). “A recession and bear market in asset prices are inevitable for the U.S. economy… All remaining questions pertain solely to speed, depth and duration of the economy’s downturn.”(2006).

Nouriel Roubini, US professor, New York University “Real home prices are likely to fall at least 30% over the next 3 years“(2005). “By itself this house price slump is enough to trigger a US recession.” (2006).

Peter Schiff , US stock broker, investment adviser and commentator “[t]he United States economy is like the Titanic ...I see a real financial crisis coming for the United States.” (2006). “There will be an economic collapse” (2007).

Robert Shiller , US professor, Yale University “There is significant risk of a very bad period, with rising default and foreclosures, serious trouble in financial markets, and a possible recession sooner than most of us expected.” (2006)

Note: for sources and more detail, please refer to the Appendix, Bezemer 2009 (cited).

No “Stopped Clock Syndrome”

Moreover Bezemer shows that his findings do not suffer from the “‘stopped clock syndrome’. A stopped clock is correct twice a day, and the mere existence of predictions is not informative on the theoretical validity of such predictions since, in financial market parlance, ‘every bear has his day’.”

He finds that accurate predictions are systematically associated with a particular type of economic model; “that ‘accounting’ (or flow-of-funds) models of the economy are the shared mindset of those analysts who worried about a credit-cum-debt crisis followed by recession, before the policy and academic establishment did. They are ‘accounting’ models in the sense that they represent households’, firms’ and governments’ balance sheets and their interrelations. If society’s wealth and debt levels reflected in balance sheets are among the determinants of its growth sustainability and its financial stability, such models are likely to timely signal threats of instability. Models that do not – such as the general equilibrium models widely used in academic and Central Bank analysis – are prone to ‘Type II errors’ of false negatives – rejecting the possibility of crisis when in reality it is just months ahead.”

Forthcoming posts will include comments on The Economist’s review of The state of Economics, and a discussion of Exit Strategies.


Anonymous said...

Just out of interest, what sort of things were you writing in 2007?

D. Mario Nuti said...

Somewhat impertinent, coming from an Anonimous reader, but a fair question.

I am not in the business of economic forecasting, but I have followed and greatly respect the work of many of the good forecasters listed by Bezemer (2009, cited above), from Godley to Roubini or Shiller, and have consistently used them in teaching in preference to work relying on the Market Efficiency Hypothesis or Computable General Equilibrium, whether or not Dynamic and Stochastic. And I put my money where my mouth was: I sold all my equities (which by then contained no sterling or dollar assets, and were well under 50% of my total financial assets) at only 10% below their peak price.

My views on globalizations are summarized in a contribution to a Round Table on the subject at the EUI, Florence, 6-7/10/2006 (published 2009), and my Federico Caffè Lectures of December 2006 (in Italian); both texts are available from my website Here are samples from both:

“ Globalisation is … distorted, for it favours the international mobility of capital rather than labour; it finances global imbalances instead of investment and growth in poorer countries; it causes turbulences, crisis and contagion; it promotes trade opening to the industrial exports of advanced countries that protect their domestic markets against the agricultural and labour-intensive exports of poorer countries…”

“In some respects globalisation has gone too fast and too far, as in the liberalisation of financial markets or weapons trade” … “In the United States … the reduction of tax and interest rates have fed not investment but the growth of real estate values and household indebtedness; the policy changes necessary to reduce existing imbalances could burst the real estate market bubble and have dramatic recessive impacts on the United States and the world economy”.