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Economists Ignored the Financial Sector

Trofim Lysenko explains genetics to a generation of young Russians while Stalin watches

Economists don’t ever quit their jobs, apparently, no matter how badly the theories they teach unsuspecting undergrads turn out. According to Mark Thoma, “Older economists have more power over journals and other key research outlets than they used to, and they have kept the topics they work on alive much longer than in the past.“ That’s really too bad. It means that unsuspecting undergrads will be taught the theories that led to the Great Crash. Of course, it does give Paul Krugman convenient targets:

So if you think the fiscal cliff matters, you also, whether you know it or not, believe that a whole school of macroeconomics responded to the greatest economic crisis since the Great Depression with ludicrous conceptual errors, of a kind nobody has had a right to make since 1936 at the latest.

Fortunately the rest of the world has been trying to keep up with reality instead of defending a failed life’s work. Certainly near the top of the list of errors is that macroeconomic models don’t include financial factors. Claudio Borio explains in a paper from the Bank for International Settlements.

Indeed, financial factors in general progressively disappeared from macroeconomists’ radar screen. Finance came to be seen effectively as a veil – a factor that, as a first approximation, could be ignored when seeking to understand business fluctuations (eg, Woodford (2003)). And when included at all, it would at most enhance the persistence of the impact of economic shocks that buffet the economy, delaying slightly its natural return to the steady state (eg, Bernanke et al (1999)).

In the US, the financial sector averaged 41% of all profits earned in the period 2000-07. In 2006, it constituted 8% of US GDP. How do you ignore that much money? Now that this theoretically irrelevant financial sector has crushed the lives of hundreds of millions of people around the world and fully established the dominance of the hyper-rich, some economists are trying to fix their models to include it. Borio’s paper describes some of the important things about the financial cycle that new models should encompass, some technical, and others more oriented to general understanding of the economy. It’s the latter category that seems so odd. How could supposedly smart people miss these obvious ideas?

For example, there is a close and easily seen relationship between the financial cycle and financial crises. Borio says: “: it is possible to measure the build-up of risk of financial crises in real time with fairly good accuracy.” That must be another one of those factors Alan Greenspan forgot to include in his failed models. How could the Maestro have known that there was a way to predict asset bubbles?

Here’s a useful thought:

The length and amplitude of the financial cycle are no constants of nature, of course; they depend on the policy regimes in place….Financial liberalisation weakens financing constraints, supporting the full self-reinforcing interplay between perceptions of value and risk, risk attitudes and funding conditions.

In other words, Alan Greenspan’s monetary and regulatory policies and the weakening of financial sector regulation by Robert Rubin and his devotees made things a lot worse. Of course, Greenspan and Rubin were just the poster boys for these horrendous errors, carried out in a spirit of True Macroeconomic Knowledge.

Apologists for the financial sector yell at us that their big contribution is to allocate savings and investment. That notion underlies the job creators meme. Borio disagrees.

More importantly, the banking system does not simply transfer real resources, more or less efficiently, from one sector to another; it generates (nominal) purchasing power. Deposits are not endowments that precede loan formation; it is loans that create deposits.

Of course, failure to grasp that idea played a big role in the asset bubbles that preceded the Great Crash.

Borio goes on to discuss policy responses to the Great Crash.

A possible pitfall here is to focus exclusively on recapitalising banks with private sector money without enforcing full loss recognition.… In the presence of investors’ doubts about the quality of banks’ balance sheets, it fails to reduce the cost of equity and funding more generally….In addition, it can generate wrong incentives: to avoid the recognition of losses; to misallocate credit, by keeping bad borrowers afloat (ever-greening) while charging higher rates to healthy borrowers; and possibly to bet for resurrection.

Senator Warren asked about bank balance sheets at a recent hearing, causing much sadness for bankers and their PR people. The Fed pumped money into the financial sector, but it and other regulators did not force loss recognition. Obama and his administration did not insist on repairing the balance sheets of consumers as required by TARP, meaning that no one knows how many of the loans on the books of banks will be repaid. Naturally, no one believes those balance sheets. They solved the problem with the Too Big To Fail subsidy, which according to the Bloomberg View’s Editorial Board created all of the profits of these monsters.

This stuff isn’t rocket science. A well-written paper like this one by Borio is easily understood in its broad scope, even if some of the technical detail isn’t. Unless, of course, you have to defend a lifetime of being wrong and damaging people.

This and other material appears in Martin Wolf’s valuable article in the Financial Times.

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