Thursday, October 21, 2010

Early Thoughts About the Financial Crisis in 2009

I've come a long way in my thinking since this post from March 2009.  At the time, I was resisting the memes of all comers regarding the cause of the financial crisis (e.g., the neoliberal Austrian's "the Fed did it along with all the poor people" and the liberals' "the banks did it"), and I was still thinking like a corporate executive.  I'd say the biggest shift in my thinking is that I used to believe that the banks were effecting the policy of the U.S. government, but now I believe that the U.S. government was effecting the policy of the banks.  Another big change is that I no longer think that the regulation we have on the books is sufficient to control the behavior of banks, who have invented new mechanisms to achieve their fraud, mechanisms not addressed by current regulations.

I also no longer frequent websites like Hullabaloo or TPM because I think they identify too much with the Democratic Party (they're not as bad as Kos, though).
What's Next: Rethinking Economics and U.S. Economic Policy
UPDATED 3/9/09 - While attempting to track down the underlying GDP data, I discovered I had misread the chart in Dean Baker's book, which refers to percentage of corporate profits, not GDP. Because of the contribution of MEW to real GDP over the last eight years, I don't know that this difference will be fatal to my thesis, but I will track the data down and shake things out.

I'm a data junkie at heart. To paraphrase Neo, I need data, lots of data. Why? Because I prefer to figure things out for myself, and the more information I have, the better I can see what others don't.

In my two-month quest to educate myself about the economy, I have gotten my hands on and at least partially reviewed on the order of forty books, some as old and revered as Smith's Wealth of Nations and others that are freshly printed screeds about the current crisis and its origins (e.g., Dean Baker's Plunder and Blunder).

I've also become something of a econ blog junkie. I visit my favorites many times a day and follow their links to source material. Calculated Risk is one of my favorites because of the wealth of data and charts.

I take a daily look at liberal political blogs like Firedog Lake, Hullabaloo and Talking Points Memo, which tend to provide the raw data and not just the opinions they've arrived at. Because it tends to be much more ideological and inflexible, I only occassionally look at DailyKos, which had this screed today, entitled "America's Lost Decade":

The problem that I have with the rant is that it ignores the larger picture and focuses instead on laying blame on the bankers and Wall Street. That's not only not helpful, it could be harmful.

The Banks Didn't Bring Us Here On Their Own; They Were Effecting U.S. Policy.

If you take a look at the U.S. economic data that has been summarized in books such as Shiller's Irrational Exuberance, Baker's Plunder and Blunder, and Reich's Supercapitalism, you will be forced to conclude that the ascendancy of the Financial sector of our economy to its acme in 2006 could not have come about but for the economic policy of the U.S. government as introduced by Reagan and carried through to this day by Obama. This economic policy, advocated by the neoclassical economists like Milton Friedman, focused on "free markets" and "globalization." U.S. investors-- individuals and corporations alike-- were encouraged by tax incentives, accounting rules and sometimes by monetary incentives (i.e., cash) to invest their capital outside of the United States. [Note: although it was published in 2005, I find the data and analysis of Irrational Exuberance the most compelling.]

The result of this economic policy was the ascendancy of the Finance sector : in 1980, the Finance sector accounted for only 15% of corporate profits, in 2004 it was 30% of the corporate profits and remained about 25% of the GDP in 2007. (See, e.g., Figure 1.1 of Plunder and Blunder) . This makes a lot of sense. As U.S. capital was invested in manufacturing infrastructure overseas, we saw domestic production of goods drop, and we had to look to something else to be the engine of growth for the U.S. economy that our manufacturing industries once served as. And that something had to grow fast enough not only to make up for the drop-off in production by the manufacturing sectors but also to provide the expected increase in overall growth that is needed to have a healthy economy generating wealth. So our economy was retooled to be driven by the service sectors of the economy, and the biggest winner of all was the Finance sector, which was deregulated and told to get out there and be fruitful. [Note: I eventually will update this post with some data that illustrate the point.] And the Finance sector, was very, very fruitful.

Unfortunately, most of the apparent fruitfulness has proven to be illusory, and the stock market today stands where it was ten years ago. Hence, we have somebody over at the DailyKos referring to the last ten years as a "lost decade" for America.

That being said, although the excesses of the Finance industry are absolutely the cause of our current economic situation, getting angry at the bankers won't help us get out of the current situation, nor will it help us to restructure the U.S. economy to grow sustainably into the future while avoiding this kind of problem again, if at all possible.

Indeed, I'd argue that focusing too much attention on the bankers will only increase the chances that are going to repeat the mistakes that led up to the current crisis. Why? Because the problem starts with neoclassical economics and the willful blind spots (e.g., inanities such as the Efficient Market Hypothesis) that its adherents have created to match the "facts" to the policy. "Oh, the data don't fit the model? No problem, just assume the data away," seems to be a touchstone of neoclassical economics, particularly Friedman and the Chicago School. For a taste of what I am talking about, check out this post by Prof. Steve Keen:

If past is prologue-- and I'm focusing on what happened in the wake of the Great Depression-- there is going to be a strong push to dramatically increase regulation of the Finance sector of the U.S. economy. People are already starting to howl for it.

While more regulation is necessary, we better be careful about how and when we implement it. Why? Because we don't have anything just yet that can replace the Finance sector as the growth engine for the U.S. economy. And we won't be able to figure out what the new growth engine (or, preferably, growth engines) are unless and until we sit down and rethink our economic policy.

This is the challenge that Obama, Bernanke and Geithner really face: neoclassical economic theory, or at least our implementation of it, has failed so spectacularly and so quickly that we don't have any other sector of the economy to turn to as the next engine of growth. As much as I hate the term, I have to call this event a Black Swan, albeit a Black Swan that arose from hubris more than anything else.

The U.S. Needs to Rethink Its Economic Policy Before We Get Too Far Down the Path of Increasing Regualtion to Punish An Industry That Was Just Doing What Was Expected of It from a Policy Perspective.

Am I saying that we have to scrap globalization and "free" markets? Nope. I think that those policies implemented wisely will win in the end. I just don't think that they can be implemented wisely if we continue to rely upon the flawed models of neoclassical economics as our guide.

Here is the current outline of my prescription for fixing this mess:

  1. Scrap neoclassical economic theory and start over by accepting that markets are inherently unstable (i.e., adopt an approach that is Post Keynesian in nature)
  2. Retool U.S. economic policy to be more balanced, both in terms of encouraging more domestic investment of capital for the production of goods and in terms of encouraging a distribution of domestic investment across multiple sectors of the domestic economy so that we can reduce the risk of the epic failure of one sector dragging the whole economy down as the Finance sector has. This is going to require a massive restructuring of corporate tax policy. Just closing corporate tax "loopholes" is not going to cut it; we're also going to have to reduce the marginal tax rates and get every corporation paying U.S. corporate taxes. We should do for corporate income taxation what Reagan allegedly did for personal income taxation. (I say "allegedly" because I don't accept the assertion but I haven't investigated it myself to say one way or the other whether it's true; I've seen arguments on both sides, though.)
  3. Completely overhaul corporate accounting rules and disclosure rules for public companies to help investors and regulators to understand what is really going on. I will detail my thinking in a later post. My bottom line here is that current rules have led to significantly overstating the rewards generated by public companies while substantially understating the risks they've undertaken, thus ultimately causing our Minsky Moment.
  4. Finally, we need to reconsider how we report economic indicators such as the GDP. My greatest concern here is that we were fooled by the combination of (1) the dominance of the Finance sector and (2) the part played by Mortgage Equity Withdrawal (MEW) in propping up the GDP starting in 2001. As a result, we overestimated the true health of the economy. People like Nouriel Roubini saw the explosion of private debt and rightly intuited that we were in for a big fall, but it sure would be nice if somebody were to point out in economic data such as the GDP how different sectors of the economy depend on one another and can falsely inflate the data. To illustrate this concern-- as I fear I am not explaining it well-- I will ask the following question: If we were to attribute spending arising from MEW to the Finance Sector instead of the sectors that received that money as income, what would we see? I think we'd see that our economy depends much more on the Finance sector than we realize, i.e., that it is responsible for more than 50% of the real GDP. Being so dependent on one sector of the economy simply isn't healthy.
Once we've taken these steps we'll be in a position to determine what additional regulations may be necessary. I suspect, however, that we'll find little additional regulation will be necessary.